People considering annuities as a long term investment must be able to choose from several different types to find the one that best suits their own financial profile. While annuities of all types share many common features and characteristics, such as tax deferral, withdrawal provisions, guaranteed death benefits, and guaranteed income, they differ greatly in the way they generate returns for investors, from fixed yields to unlimited returns from stock and bond investment accounts. As with any investment choice investors make, the decision must be based largely on their own objectives, priorities and tolerance for risk. The same criteria should be applied when considering fixed vs variable annuities.

What They Have in Common

Fixed and variable annuities share many of the features and characteristics that make all annuities unique as investment vehicles. They both have accumulation accounts that allow for the earnings to grow tax deferred. They both allow for withdrawals to be taken without charge as long as they don’t exceed 10% of the account value in any year. They both provide a guaranteed death benefit and they both guarantee a lifetime of income. They each include a minimum rate guarantee, although, with a fixed annuity the guarantee is a part of the standard contract, whereas, with variable annuities, it must be selected and paid for as a separate option if it is available.

The Big Difference

The primary difference between the two types of annuities lies in the way the rates of return are generated for the accumulation accounts. It is this distinction which places them at opposite ends of the investment risk and reward spectrum separating their compatibility for risk-adverse and risk-oriented investors.

Fixed Annuity Returns

The rate of return on fixed annuities is determined by yield generated on investments in the general account of the life insurance company. Investor deposits are invested in a portfolio, consisting of yield bearing instruments such as government and corporate bonds. The yield that is credited to annuity accounts is a portion of the yield the insurance company manages to generate on its portfolio.

Most fixed annuities offer a rate guarantee that locks in the rate for a period of time, from one to 10 years. Generally, the longer the rate guarantee, the higher the initial rate. The length of the rate guarantee is typically tied to the length of the surrender period in which withdrawals that exceed 10% are charged a surrender fee.

At the end of the guarantee period, the rate is adjusted to reflect the current investment experience of the general account, or some predetermined adjustment formula. The minimum rate guarantee included in fixed annuity contracts ensures that the adjusted rate won’t fall below a floor rate.

Variable Annuity Returns

The biggest difference with variable annuities is that their accumulation accounts are separate from the general account of the life insurer. These separate accounts are set up much like mutual funds within a retirement plan, wherein investors can select from a family of accounts to create a diversified portfolio of stocks, bonds, fixed investments, and real estate funds. The separate accounts, managed by investment managers, generate rates of return based on the performance of the underlying portfolio of investments.

While the returns are unlimited on the upside, so are the risks on the downside. As with mutual fund investments, investors are able to allocate their funds among different types of stock and bond accounts to create a diversified and balance portfolio that can stabilize the rate of return and reduce risk exposure. Investors can transfer between investment accounts so that they can maintain the balance of investments appropriate for their investment objectives and risk tolerance.

Although variable annuities don’t include a minimum rate guarantee in their contracts, they do offer investors two forms of principal security. The first is through a guaranteed death benefit, which ensures that the investor’s beneficiary receives no less than the investor’s original investment as a death benefit. Many contracts also provide a ratcheting mechanism that ratchets up the principal at various times to include gains made in the account, so once the gains are achieved, the principal, or basis in the account will increase.

Additionally, some variable annuity contracts include an option to purchase a minimum rate guarantee, so that, in the event of a decline in portfolio value, the separate accounts will still be credited with a positive rate of return. There is a charge for this option, but for many investors, it’s an insurance premium worth paying.

Will it be Fixed or Variable

With an understanding of the main distinguishing feature of fixed and variable annuities, most investors will line up behind one or the other based on their individual risk-reward profile. Investors who understand market risk and the basic investment premise that higher rewards come with a commensurate amount of risk will consider variable annuities, while, investors who want to avoid risk at all cost, and are willing to accept a lower return to do so, will consider fixed annuities.

It Doesn’t Have to be ‘Either-Or’

One of the lessons learned from many of the pre-retirees who are finding that their accumulated retirement savings have fallen short of their expectations is that the need for a growth element in a retirement portfolio doesn’t go away. Retirement incomes that must last a lifetime need to be able to keep up with the rate of inflation, and retirement savings need continued growth throughout the accumulation years. For most investors, accumulating the funds needed for a secure retirement requires that a significant portion of their assets continue to work harder in growth oriented investments.

A combined fixed and variable annuity strategy can produce the upside returns needed for continued growth in retirement savings as well as stability and predictability. And, when the accumulation phase gives way to the income phase, the variable annuity can generate an income that increases over time to protect purchasing power while the fixed annuity provides the security of an income safety net.

Comments Off

Comments are closed.