There are two types of deferred annuities: fixed and variable. An insurance company invests monies from fixed annuities in bonds, while variable annuities are tied to stocks, mutual funds, commodities and other market indicators.
Difference Between Fixed and Variable Annuities
Annuities are investments that can ensure long-term growth while preserving the underlying principal. There are several types of annuities to choose from, allowing you to find one that will be most effective in furthering your financial goals.
With a fixed annuity, your premium is placed in the insurance company’s general account and that money is mostly invested in different types of bonds. A variable annuity is connected to the performance of another financial instrument, such as stocks, mutual funds, precious metals or commodities.
Both fixed and variable annuities can be immediate or deferred annuities. Annuitants with immediate annuities begin to receive payments from the annuity shortly after purchasing it. Annuitants with deferred annuities don’t begin receiving payments for many years or even decades after they purchase the annuity.
What Are Fixed Annuities?
Fixed annuities offer a guaranteed payout because they have a set rate of return. For the first year of the annuity, the rate is fixed. After that, the insurance company can raise or lower the interest rate on a yearly or multi-yearly basis, but not below a guaranteed minimum. There is no upper limit on contributions, and taxes on the growth are deferred until withdrawal.
Pros and Cons of Fixed Annuities
If you are older than 59½, you can make annual withdrawals of up to 10 percent of the account’s value every year with no penalty. Those under age 59½ pay a penalty to the IRS for early withdrawals.
Fixed annuities have several payout options, including lump-sum withdrawals, periodic withdrawals or a combination of the two.
- These annuities offer guaranteed payouts, but the payment is guaranteed by the insurance company that issued it, not the government. If the insurance company goes out of business, an annuitant could lose money.
- Annuities earn interest over time, but if the interest rate falls below the rate of inflation, the annuitant could lose spending power.
- Without purchasing a costly death-benefit rider, annuitants may not be able to have a beneficiary receive the remainder of their annuity, should they die before receiving the full amount.
Fixed Annuity Fees
Fixed annuities, in general, are not known for carrying a number of fees. Still, there are some fees that can be tacked on to any type of annuity.
- Surrender Charges
- If you make withdrawals from your annuity within the first 10 years after you purchase it, the insurance company will charge you surrender fees. Surrender fees can run anywhere from 7 to 20 percent of the amount withdrawn in the first year, and decrease by 1 percent each year until it reaches zero.
- Annual Fees
- Annuities often carry annual insurance charges and investment management fees, which can range from 0.5 to 2 percent or more.
- If you worked with a salesperson, they may earn a commission for selling you an annuity. Check the fine print for possible commission fees, which can go as high as 10 percent in some cases. To avoid paying commission, look for “direct sold” annuities.
- Income Rider
- Income riders are an added benefit on top of an annuity that guarantees a lifetime income stream. This added benefit has an added cost, which can include a contractual fee in addition to the annual rider fee.
What Are Variable Annuities?
Variable annuities are structured around the stock market and other fluctuating financial instruments, and therefore can vary in profitability. When you purchase a variable annuity, your premium is distributed into various sub-accounts that align with your preferred level of risk.
Pros & Cons of Variable Annuities
Similar to fixed annuities, variable annuities grow tax-deferred, have no upper limit on contributions and offer different payout options. Just like fixed annuities, variable annuities can pay out in a lump sum, in smaller payments over time, or a combination of both.
One benefit of variable annuities is they let you receive period payments for the rest of your life or the life of a beneficiary such as a spouse. This protects you against the possibility of outliving your investments. The other advantage offered by variable annuities is they come with a death benefit. If you die before payments have started, your beneficiary will receive a specific amount of money, usually at least the amount of your payments. This happens even if your account has lost money and contains less than the guaranteed, set amount for the beneficiary.
- The value of variable annuities is always at risk because it is tied to other financial products.
- Without the purchase of extra, costly riders, variable annuitants may run out of money before death, or lose any profits to the insurance company after death, depending on the performance of the annuity.
Variable Annuity Fees
In addition to the principal of the annuity, variable annuities carry fees. In fact, the national average fee for a variable annuity is 3.61 percent, and it can even go over 5 percent.
- Administrative Fees
- Variable annuitants receive regular updates on the status of their accounts. Insurance companies often charge a small fee — anywhere from 0.1 – 0.3 percent of the policy value — to cover the cost of this service.
- Investment Expense Ratio
- The sub-accounts your variable annuity are invested in will incur annual investment management fees, likely ranging from 0.25 – 2 percent of the policy value.
- Income Riders and Mortality Expenses
- Annuitants can eliminate some of the risk associated with a variable annuity by purchasing extra security in the form of riders. For an extra fee, income riders guarantee the annuitant will always receive a payment for the remainder of their lifetime, and mortality expenses provide a death benefit, so the annuitant’s beneficiaries may receive the remainder of their funds after their death.
Should You Sell Your Variable Annuity?
When you want out of your variable annuity contract, you have options. You could exchange your contract for a new annuity contract. This is allowed under Section 1035 of the U.S. tax code. This is helpful if you find another annuity with better features for your situation, such as more investment options. If you are still in the surrender charge period of your old annuity, you may be charged that fee, which can be as high as 9 percent. If you’re considering this exchange, you should be cautious and thorough about reviewing the contracts and whether you want to begin a new surrender charge period by starting in a new contract. The surrender charge period is typically from six to eight years, but can be as long as 12 years, depending on the contract. You should also consult with a tax professional or investment advisor to ensure that this exchange will indeed be tax free. To avoid taxes, the exchange can’t involve surrendering the old annuity for cash and then buying a new annuity with the money. Authorities warn that these exchanges may be bad for consumers, who may wind up losing money,
You could also sell all or part of your annuity to a company that specializes in buying annuities. This option should be explored before you try to cash in or change your annuity through your annuity provider. There’s a good chance that selling your annuity will get you a better return than other choices.
Variable Annuity Accumulation and Payout Phases
The accumulation phase of your variable annuity is the period during which you make payments that you direct toward particular investment options. These options should be explained in detail in the annuity company’s prospectus, which you should read and understand. For example, you could allocate a percentage to a bond fund, some to a domestic stock fund and the rest to an international stock fund. You might also choose to send some to a fixed account, which pays a set rate of interest, typically with a guaranteed minimum rate. During this phase, you usually can transfer money between accounts, but you may be charged a transfer fee. If you withdraw money during this phase, you may have to pay surrender charges and potentially a 10 percent federal tax penalty if you are under the age of 59 ½.
The payout phase is when you may receive your purchase payments, plus investment income, either as a lump sum or at regular intervals. If you receive the payments periodically, you can choose how long the payments will last. This can be for a set period of years or an indefinite period, such as your lifetime or the lifetime of you and a beneficiary, such as your spouse.
- Rose, J. (2015, March 28). 5 Reasons Why You Should Never Buy A Variable Annuity. Retrieved from https://www.forbes.com/sites/jrose/2015/03/28/5-reasons-why-you-should-never-buy-a-variable-annuity/#4a3ef8574c6b
- Securities and Exchange Commission. (2007, September). Variable Annuities. What You Should Know. Retrieved from https://www.sec.gov/investor/pubs/sec-guide-to-variable-annuities.pdf
- Financial Industry Regulatory Authority. (2006, March 2). Should You Exchange Your Variable Annuity? Retrieved from http://www.finra.org/investors/alerts/should-you-exchange-your-variable-annuity
- Powell, R. (2013, November 16). Variable annuities: right or wrong for you? Retrieved from https://www.marketwatch.com/story/variable-annuities-right-or-wrong-for-you-2013-11-16