Fixed vs. variable annuities

In another article "Annuities Explained" we provided an overview of each type of annuity as well as their general pros and cons. Here we take a deeper look of fixed and variable annuities so you get to choose the right product for your needs.

Fixed Annuities

A fixed annuity may appeal to a consumer who prefers a safe investment vehicle. This is because the returns are guaranteed. In this type of annuity, a consumer invests a sum of money and in return he gets to be paid with regular monthly checks or he may opt for a lump sum.

How it works:

In this type of annuity, the insurance firm guarantees the return over a certain period of time. The firm cannot deny payment to a policyholder; whether the investments in an annuity make profit or take on a loss, the company still has to pay the individual.

Interest earned on a fixed annuity is accrued on a yearly basis. The tax on the money invested therein is deferred until it is taken out. Generally, this type of annuity has a one-year flat interest rate, which may change every year but will not go lower than the guaranteed rate.

Advantages:

  • Low minimum amount required to invest; from $1,000 to $10,000.
  • The possibility of losing money is low.
  • The consumer gets to have his money back in the event of insolvency on the part of the insurance company.
  • The amount invested in a fixed annuity is covered by the state in the event of insolvency of the insurance company. Coverage is up to a certain limit.
  • Interest rate is fixed - which means returns are assured even if the market gets unstable.
  • Tax-deferred. Growth of investments is tax-free. Once payments are received then that is the time the consumer gets taxed.
  • Availability of long-term as well as short-term fixed annuities.
  • Choice of immediate (after purchase) or deferred (after a period of time) payments.
  • Choice between getting a lump amount or monthly payments.
  • Often this type of annuity provides lifetime income, which may protect the consumer against the possibility of outliving their retirement funds.
  • Certain types give the consumer the choice of life insurance with death benefits. This may allow an individual to leave behind money to their family without them having to undergo the probate process.

Disadvantages

  • They can be expensive especially in comparison to non-annuity investment options.
  • The IRS may charge the consumer a 10 percent penalty for premature withdrawal. Only when the consumer reaches the age of 59 and a half is he allowed to withdraw without fear of being taxed.
  • Not advantageous particularly to young individuals because the money invested cannot be withdrawn before the allowed age.
  • Rates of interest are not as high as with comparable investment vehicles like mutual funds.
  • If the consumer has extra money he is not allowed to add this to his annuity account. He would need to buy another annuity with his extra money.
  • Tax-deferred gains are classified as ordinary income for deferred, fixed type annuities. This means these are not classified as capital gains --- the difference, tax-wise, is significant as ordinary income gets taxed at a higher rate.
  • Difficult to maximize returns because costs can eat a large chunk of the annuity's returns.
  • Considered too complicated to understand by many consumers.

Variable Annuities

The most appealing feature of a variable annuity, as compared to a fixed one, is the chance for the money to grow especially during times when the stock market is performing well.

How it works:

The variable annuity undergoes two phases: the first one is the accumulation phase and the second one is the payout phase.

In the first phase, the policyholder makes purchase payments towards the annuity. The policyholder makes use of these payments to distribute among several sub-accounts. How each sub-account performs will dictate the overall performance of the variable annuity that in turn impacts the payments that the policyholder gets during the payout phase.

Advantages

  • When the stock market performs well, the investment in the annuity would also perform well. This leads to more money for the consumer in the future.
  • Allows the policyholder to choose where he wants to put his money in - it can be in stocks, bonds or mutual funds. Those who are wise investors are provided the chance to maximize their future returns with this type of annuity.
  • There are no minimum requirements regarding distributions. This is advantageous to individuals who own many assets, or, those whose family history is full of members living long lives.
  • Just as with IRAs or 401(k)s, funds invested in a variable annuity along with the interest earned does not get taxed until the time it is taken out.
  • As with many annuities, it may come with a death benefit which pays out money to beneficiaries in the event the policyholder dies prematurely.
  • The tax-deferral feature enhances the earning capability of a variable annuity as higher growth can be achieved as the gains of the account are accumulated free of yearly taxation.

Disadvantages

  • If earnings go down, the total worth of the annuity also go does down. In comparison, fixed annuity holders get guaranteed income regardless of how the market performs.
  • Money invested cannot be withdrawn until they reach the age of 59 and a half. A 10 percent penalty is assessed when a policyholder takes out his money earlier than he should.
  • Early withdrawals also mean less income because the money is not allowed to grow to its fullest.
  • Getting taxed as ordinary income instead as capital gains.

Comparing risk levels and earning opportunities

Fixed annuities are the less risky between the two. This is because they are usually invested in conservative instruments like corporate and government bonds as well as other investments that are non-stock market in nature.

Because of the conservative nature of this type of annuity, the earnings may be relatively less. The rate guaranteed on a fixed annuity may even be lower than the interest rate on a savings account.

Another thing about fixed annuities, the policyholder does not have control over his money.

Variable annuities, on the other hand, are riskier but they offer the better chance of getting the most out of one's money. Usually, variable annuities are invested in less conservative instruments such as money market funds, mutual funds consisting of bonds and stocks, equity indexes as well as government securities.

One thing about variable annuities that many people like is that they allow the policyholder control as to where the money is invested.

In terms of earning opportunities, a fixed annuity guarantees a minimum rate of interest. The investments in this type of annuity may earn more than the minimum rate. However, the insurance company will get to keep the difference.

On the other hand, the variable annuity may earn more because of the nature of investments covered therein. Growth opportunities can be maximized. However, this type of annuity is dependent on the performance of the stock market. If the market goes down, so does the value of the annuity.

How rate of returns are determined

In general, the insurance company may consider the following when setting the rate:

  • Expected net earnings of the company
  • The margin set between net earnings rate and the guaranteed rate
  • The experience with factors like mortality, persistency and expenses
  • Business risks
  • Likelihood of bad market conditions like severe inflation

In the case of fixed annuities, these provide a guaranteed, minimum interest rate. This is stated in the policy and can range from 1.5 percent up to 3 percent.

Fixed annuities may feature an initial rate of interest, which is higher than the guaranteed rate. This is usually in effect for one year. This rate is applicable to the initial deposit made by the policyholder.  The purpose of this initial rate is to serve as a bonus to the policyholder. After the expiration of the initial rate period, the company will offer a renewal rate on the policy. This new rate often follows the current state of the market and will never go down lower than the guaranteed minimum rate.

In the case of variable annuities, the rate of return is dependent on each of the sub-accounts on which the policyholder decided to invest his purchase money. Each sub-account has its own rate of return which is independent from those of the other sub-accounts. The rates of return of all these investments determine the overall performance of the annuity and eventual payout that the policyholder will get.

Taxation

Annuity payments to the policyholder may either be a single lump amount or a series of payouts regularly done over a period of time. Whatever method the policyholder opts, he will be taxed on the payments he will get. In the case of a lump sum payment, the amount that will be taxed is the difference between the purchase price and the amount received by the policyholder.

In the case of regular monthly payments, a portion of each of these payments may represent earnings and these will be subject to tax.

Taxation on variable annuities are slightly different. This is because how much will be earned by the annuity remains uncertain. The market value of the money invested will depend on how the sub-accounts perform.

Detailed discussion is provided in U.S. IRS publication on annuities and pensions which can be found in this link: http://www.irs.gov/uac/Publication-939,-General-Rule-for-Pensions-and-Annuities.

Fees and charges

Fixed Annuities:

Majority of fixed annuities do not carry fees with the possible exception of a yearly policy fee, which can range between $25 to $50 per year. This fee may also be waived if a consumer invests a certain minimum amount, for example, $25,000.

Variable annuities:

Variable annuities are notorious for their expensive charges which can reach up to 3 percent per annum. These fees and charges can be categorized as follows:

  • Mortality Expenses or M&E. This fee provides the policyholder a guarantee that in the event of his or her death, the beneficiaries will be paid, at the minimum, an equivalent of the money invested in the annuity. This charge can fall between .50 percent to 1.5 percent per year.
  • Administrative charges. These cover a range of expenses like ongoing services and mailings and can cost between .10 to .30 percent of the annuity value per year.
  • Investment Expense Ratio. This covers the cost of managing the different sub-accounts found in variable annuities. This expense can range between .25 percent to 2 percent of the value of the annuity per annum.
  • Riders. Riders can range between .25 percent to 1 percent of the value of the annuity per annum.

Withdrawal or surrender charges

If a policyholder opts to access his money during the accumulation phase, he may be allowed to get all or a portion of the annuity's value. If only a portion is taken out, he may be required to pay a withdrawal fee.

If all the money is taken out and the policyholder opts to terminate or surrender the annuity, he may have to shoulder a surrender fee. The insurance company will usually set the fee as a percentage of the value of the annuity, the amount being withdrawn or the total premiums paid.

The company may also decide to lessen or even eliminate the surrender fee if the policyholder has had the contract for a certain number of years. When the company pays a death benefit, it may opt to waive the surrender fee.

The company's withdrawal or surrender fees are aside from the federal penalty of 10 percent which is assessed when the policyholder decides to withdraw his money before he reaches the age of 59 and a half.

Which one to choose?

Key questions to ask when considering a fixed annuity:

  • How will a fixed annuity fit into your retirement plan?
  • How much investment should you invest in a fixed annuity?
  • What tax consequences will you face now and in the future?
  • Is there a need for you to buy an income rider?
  • When is the time for you to buy a fixed annuity?
  • Can you be disciplined to avoid making withdrawals before you are allowed to make them without being penalized or assessed with fees?

Key questions to ask when considering a variable annuity:

  • Will the variable annuity be used for retirement or for other long-term needs?
  • How will it fit into your retirement plan?
  • Will you be making your investment via a retirement plan or will it be via IRA (the implication here is that you will not receive any additional tax-deferred benefit)
  • Can you afford to take the risks involved with investing in the various sub-accounts?
  • Do you have a clear understanding of how a variable annuity works?
  • Are the costs involved okay with you?
  • Do you foresee making early withdrawals?

Choosing between a fixed and variable annuity will depend on what needs you want to fill with respect to your retirement fund. If you think you need a regular stream of income during retirement, a fixed annuity is for you. If you want to take an active role in investing and you have the appetite for risk-taking, then a variable annuity might be for you.

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