What Is the Primary Difference Between Fixed and Variable Annuities?

An annuity represents a contract between an individual and an insurance company, designed to provide a steady stream of income, often utilized during retirement. Individuals typically make either a single payment or a series of payments to the insurer. In return, the insurance company agrees to disburse regular payments back to the individual, either immediately or at a specified future date. This financial arrangement serves as a tool in financial planning, helping individuals address the concern of outliving their savings by establishing a reliable income source.

Fixed Annuities Explained

A fixed annuity functions as a contract with an insurance company that guarantees a predetermined interest rate on the principal invested. This structure ensures that the contract value grows steadily and predictably, unaffected by market fluctuations.

The insurance company assumes the investment risk with fixed annuities, placing the funds into its general account. This arrangement means the annuitant’s principal and accumulated interest are guaranteed by the claims-paying ability of the issuing insurance company. As a result, the income payments received from a fixed annuity are stable and predictable, making them suitable for those who prioritize security and reliable income.

Earnings within a fixed annuity grow on a tax-deferred basis, meaning taxes are not due until withdrawals are made. This tax deferral allows the earnings to compound more efficiently over time. While fixed annuities offer stability, they generally provide more modest returns compared to market-linked investments.

Withdrawals from a fixed annuity before age 59½ may incur a 10% federal income tax penalty. Insurance companies may also impose surrender charges if funds are withdrawn prematurely, typically within the first few years of the contract. These charges can be as high as 10% in the initial years, gradually declining over a surrender period.

Variable Annuities Explained

A variable annuity is a contract between an individual and an insurance company where the value of the annuity can fluctuate based on the performance of underlying investment options. These investment options, known as subaccounts, are similar to mutual funds and can include stocks, bonds, or money market instruments.

The funds invested in a variable annuity’s subaccounts are held in a separate account, legally segregated from the insurance company’s general assets. This separation protects the annuitant’s investment from the insurer’s general creditors. While variable annuities offer the potential for higher returns through market participation, they also expose the annuitant to investment risk, meaning the contract value can decline due to market downturns.

Variable annuities also offer tax-deferred growth on earnings, similar to fixed annuities. This allows investment gains to accumulate without immediate taxation until withdrawals begin. However, these products typically come with various fees and charges, which can include mortality and expense risk charges, administrative fees, and subaccount management fees.

Mortality and expense (M&E) charges range from 0.20% to 1.80% annually, compensating the insurance company for insurance risks and guaranteed benefits like death benefits. Administrative fees cover record-keeping and other service costs, and can be a flat annual fee or a small percentage of the account value.

Core Distinctions

The fundamental difference between fixed and variable annuities lies in how their contract values grow and the associated risk. Fixed annuities provide a guaranteed interest rate, ensuring predictable growth that is not tied to market performance. Conversely, variable annuities allow for market-linked growth, with their value directly influenced by the performance of chosen investment subaccounts.

Risk exposure significantly differentiates these two annuity types. Fixed annuities offer principal protection and interest rate guarantees, with the insurance company bearing the investment risk. This means the annuitant’s capital is secure, subject to the insurer’s financial strength. Variable annuities, however, place the investment risk on the annuitant, meaning the contract owner can experience losses if the underlying investments perform poorly.

Income payouts also vary considerably between the two. Fixed annuities deliver predictable and stable income streams once payments begin, as the payout amount is determined by the guaranteed growth of the contract. Variable annuity income payments can fluctuate, with the amount received directly dependent on the ongoing performance of the selected subaccounts.

Fees represent another notable distinction. Fixed annuities generally have lower and more straightforward fee structures, often limited to surrender charges for early withdrawals. Variable annuities, in contrast, typically involve higher and more complex fees, including mortality and expense charges, administrative fees, and underlying investment management fees for the subaccounts.

Regarding investment control, fixed annuities offer limited choice, primarily focusing on the guaranteed interest rate offered by the insurer. Variable annuities provide annuitants with greater control, allowing them to select from a diverse menu of subaccounts to align with their investment objectives and risk tolerance. This choice enables potential for higher returns, alongside the inherent market risk.