Variable, Fixed & Indexed Annuities: Why You Need To Take A Fresh Look

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Estimated reading time: 17 minutes

Picture this scenario in your mind. You’ve come across terms like variable, fixed, and indexed annuities, but you’re not entirely sure about their meaning or mechanics. You’re genuinely intrigued and decide to turn to someone you believe to be well-versed in annuities, perhaps even considering themselves an investor. However, instead of clarifying your doubts, their explanation overwhelms you, leaving you even more perplexed. Sound familiar?

Those who are aware of your contemplation regarding an annuity have most likely openly expressed their opinions on the matter. They tend to share everything they have heard, both the positive and negative aspects, and everything they claim to know, regardless of its accuracy. Subsequently, they often offer their own suggestions like, “You should/shouldn’t [fill in the blank here].” It doesn’t take long to realize just how drastically the opinions vary. Can you sense the shift?

If you’re considering retirement planning, you’ve probably come across the idea of using annuities to generate retirement income. But what exactly are annuities, and how can you determine if they’re suitable for your specific needs? Let’s explore this topic and gain a better understanding.

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Comparing Annuities

With a plethora of annuity products to choose from, each boasting different features, associated costs, and restrictions, it can be challenging to discern the one that aligns best with your retirement needs and objectives. So, where should you start? Let’s begin by exploring their classifications.

Classification of Annuities

Annuities can sometimes puzzle people due to their categorization based on various characteristics. The three most prevalent types of annuities are variable, fixed, and indexed annuities. Each of these annuity variants is classified according to their underlying investments.

Variable Annuity

Variable annuities invest funds in a portfolio, causing the account value to fluctuate based on its performance. State authorities and the U.S. federal level regulate these annuities. Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA).

Fixed Annuity

A fixed annuity invests in a secure account, guaranteeing the principal value. However, due to this guarantee, the rate of return is generally lower. Furthermore, a fixed annuity does not provide protection against inflation, which can be perceived as a disadvantage.

Moreover, state insurance commissioners regulate fixed annuities.  That said, be sure to check with your state insurance commission about the risks and benefits of fixed annuities. Additionally, ensure that the insurance broker providing services in your state is registered.

Indexed Annuity

Equity-Indexed Annuities, alternatively known as Fixed-Indexed Annuities, possess a distinctive combination of features from both fixed and variable annuities. These annuities not only guarantee a minimum interest rate, but also link the interest rate to a market index. Embrace them as a refined hybrid that blends the finest aspects of fixed and variable annuities.

Indexed annuities commonly rely on renowned indices, such as the S&P 500 Composite Stock Price Index. However, there are variations that utilize indexes representing different market segments. Even more enticingly, certain indexed annuities offer investors the flexibility to choose from a range of indexes.

Because of the guaranteed interest rate, indexed annuities give you more risk (but more potential return) than a fixed annuity, but less risk (and less potential return) than a variable annuity.  Most indexed annuities are not registered with the SEC, but it’s important to note that an indexed annuity can be a security. Instead, indexed annuities are regulated by state insurance commissioners.

Variable Annuity Definition

What exactly is a variable annuity? Insurance companies offer variable annuities as a retirement savings product. It allows you to invest your money in professionally managed portfolios, aiming to provide long-term growth. Think of it as a way to secure your financial future while benefiting from expert investment management, similar to mutual funds.

Your funds grow tax-deferred until you opt to receive income in the future. When you purchase an annuity, you usually get a standard death benefit that guarantees a lasting legacy for your loved ones.

Investing + Insurance = 4 Advantages

Get ready to be captivated. The fusion of investing and insurance birthes a one-of-a-kind, powerhouse product that ignites your retirement plans! Let’s delve into the four striking advantages it offers:

1. Choice and Flexibility
2. Annuity Tax Benefits
3. Opportunity for Guaranteed Lifetime Income
4. Legacy Protection

Choice and Flexibility

When it comes to investing, there’s one thing almost everyone agrees on: diversification is key to minimize the risk of financial loss. With variable annuities, you have access to a wide range of investment options across different asset classes, strategies, styles, and sectors. By spreading your money among various investments, you can effectively mitigate risk during market downturns.

Variable annuities provide the added flexibility of transferring funds between investment options within the contract, without incurring any sales or withdrawal charges. This feature not only enhances the efficiency of managing your investments but also preserves the freedom to adjust your portfolio as needed.

Tax Benefits

A variable annuity offers the advantage of tax-deferred growth, allowing your account to accumulate without taxation until you decide to withdraw funds at a later stage (possibly when your tax bracket is lower). So, instead of paying annual taxes, the money stays in your account and keeps growing until you withdraw it.

In addition, there are extra advantages to enjoy, such as the ability to flexibly rebalance and strategically reallocate funds within your investments, all without the burden of annual taxes.

It’s important to know that you can only take advantage of tax-deferral if you buy your annuity with money from outside of “qualified” retirement accounts, such as 401(k)s, 403(b)s and IRAs (because these are tax-deferred already). Many people choose to do so anyway, because they want to take advantage of the annuity’s other features and benefits, including death benefit options, range of investments and guaranteed income payout options.

Income Guarantees

Annuities offer two methods to secure your retirement income, making it possible for you to enjoy financial stability in your golden years. So, it’s time to ensure a steady stream of income for a worry-free retirement..

Annuitization:

When you’re ready to start receiving income, you can choose to annuitize. This entails transferring the control of funds in your account to an insurance company, which will then provide you with a steady and dependable stream of income payments throughout your retirement.

You can structure the payments in various ways: lifetime, for a specific period (usually 10, 20, or 30 years), or a combination of both (e.g., lifetime with 10 years). Upon passing away, the insurance company assumes the responsibility of fulfilling the remaining payment obligations to your chosen beneficiaries for the designated timeframe and retains any remaining funds.

Optional Lifetime Income Guarantees:

Modern annuities not only offer annuitization but also present living benefits, for an extra fee, that function similarly but with enhanced flexibility. These benefits provide income guarantees, including lifetime income, ensuring your future earnings while maintaining full control over your finances. Experience the advantages of annuities with added peace of mind and financial security.

By purchasing a variable annuity with an ‘income guarantee’, you can shield your future income level, regardless of how poorly your account’s investments perform. Furthermore, select living benefits not only provide guaranteed income growth but also allow you to seize gains during market upswings. Once you commence receiving income, you have the flexibility to withdraw a fixed amount each year, ensuring a lifelong stream of guaranteed income, subject to the terms specified in your contract.

Usually, these optional lifetime income benefits come with an added cost, but they can also be directly integrated into the annuity itself.

Legacy Protection

Fortunately, most annuities today offer a standard death benefit to help provide a legacy for your loved ones. Typically, the process is as follows: Upon the owner’s demise, the beneficiaries will receive at least the amount the owner contributed to the annuity, excluding any withdrawals, OR the annuity’s current account value — whichever is greater.

The variable annuity usually includes the death benefit at no extra cost. However, certain annuities provide enhanced death benefits for an extra fee, so remember to carefully review your contract.

Things to Consider When Purchasing a Variable Annuity

• Will you use the variable annuity primarily to save for retirement, or a similar long-term goal?
• Are you willing to take the risk that your account value may decrease, if the underlying mutual fund investment options perform badly?
• Do you understand all of the fees and expenses that the variable annuity charges?
• Do you intend to remain in the variable annuity long enough to avoid paying any surrender charges, if you have to withdraw money?
• Are there features of the variable annuity, such as long-term care insurance, that you could purchase more cheaply, if purchased separately?
• Have you consulted with a tax adviser and considered all the tax consequences of purchasing an annuity, including the effect of annuity payments on your tax status in retirement?
• If you are exchanging one annuity for another one, do the benefits of the exchange outweigh the costs? Such as any surrender charges you will have to pay, if you withdraw your money before the end of the surrender charge period for the new annuity?

If you’d like to dive deeper into the variable annuity pool, be sure to check out the SEC Guide to Variable Annuities.

Fixed Annuity Definition

A fixed annuity is a financial instrument that offers a guaranteed minimum interest rate on your principal while your account grows. Additionally, the insurance company ensures that the periodic payments will remain fixed for a specific duration, such as 20 years, or even for your lifetime. This provides stability and certainty in your financial planning while allowing your investment to flourish.

Although the word “fixed” might suggest otherwise, the interest rate on a fixed annuity can  change over time. The contract will provide clear explanations regarding the terms, conditions, timing, and circumstances under which this can occur. Typically, the interest rate remains fixed for a certain period of time, after which it adjusts periodically in accordance with prevailing rates.

Things to Consider When Purchasing a Fixed Annuity

While a fixed annuity can remove market risk from your returns, there are other risks to consider when deciding if a fixed annuity is for you.

• An annuity’s “guarantee” is only as strong as the insurance company that issues the annuity. If the insurance company that issues the annuities fails, it’s important to note that they are not guaranteed by the FDIC, SIPC, or any other federal agency. State guarantees may apply in such cases. contract fails.
• Payments in a fixed annuity typically do not have cost-of-living adjustments to keep pace with inflation, so the value of the money you receive in your payments may decline over time. You can purchase annuities with inflation protection, but they generally come with a significantly higher cost.
• It may be difficult to get your money back once you pay the premium to the insurance company. Even if you only receive a few payments under a fixed annuity contract, the insurance company may not be obligated to continue payments to your spouse or refund your premiums to your estate.
• If there are changes to your fixed annuity and you want to withdraw your money early, you could incur surrender charges that cut into your returns.

Fixed Indexed Annuity Definition

A fixed indexed annuity (FIA) is a tax-deferred financial vehicle provided by insurance companies. This tool is a long-term investment that safeguards against market loss. It also offers growth potential based on the performance of your chosen index or combination of indices. This strategic blend allows you to safeguard your account value while seizing the opportunity for expansion.

An FIA (Fixed Indexed Annuity) offers a unique approach to investing your money. Instead of directly investing in an index, it allows the potential to earn interest based on the index’s performance. To ensure a balanced approach, the insurance company imposes certain limits. These include an upper limit or “cap” that restricts the amount of interest credited within a given period. Additionally, there is a “floor” that offers protection against downside risks, ensuring stability and peace of mind.

It is crucial to bear in mind that you cannot experience financial loss due to a market decline. This sense of security and tranquility is what makes fixed indexed annuities incredibly appealing.

You also have the option to allocate your funds to a fixed rate strategy, guaranteeing an interest rate. When ready to receive income, choose to annuitize your contract for a specific duration or for life. Make the most of these choices by taking an active role in managing your finances.

How a Fixed Indexed Annuity Works

Fixed indexed annuities provide you with various strategies to potentially grow your money. You can choose between a fixed interest rate option or index-based options. These credit your interest based on cap rate or participation rate strategies. This also offers flexibility and the opportunity to optimize your financial outcomes.

The fixed interest rate strategy offers a guaranteed interest rate for a one-year term. When you buy a contract, the interest rate is determined and gets renewed annually on your contract anniversary date. This is based on the prevailing rate at that time.

Index-based strategies offer the potential for your money to grow. Market indices, such as the renowned S&P 500®, heavily influence this. Usually, annuities calculate the interest rate earned over a specific time period and can vary based on different annuity features. You can allocate your funds to a strategy based on a cap rate or participation rate. This way, you can optimize your investment for growth while ensuring flexibility and potential returns.

What the Cap Rate Represents

Cap rate is the maximum interest credited during the term, while the participation rate sets an upper limit. This is based on a specified percentage of the index’s performance. After each term, both rates reset.

A secure floor safeguards your principal and earnings, preventing potential value erosion in your annuity if the index declines. It fully protects your investment, shielding both the principal and credited interest from market fluctuations.

Opportunities for Growth

‘Optional benefits’ in annuities offer two ways to boost retirement income: through roll-up rates and securing account highs.

The roll-up rate, when you choose to purchase optional benefits, signifies the guaranteed growth rate of the annuity. It stays unchanged throughout the entire duration of your benefit, set at the time you signed your application.

Furthermore, annuities offer optional benefits with lock-ins, enabling you to capture market gains for your annuity account at specific intervals. Generally, annuities offer the opportunity to lock in account highs on an annual, quarterly, or monthly basis. In some cases, they offer daily lock-in opportunities, ensuring steady growth of your retirement income despite market fluctuations.

Annuity Accumulation Phase

There are two phases to a deferred annuity:

1. The Accumulation Phase
2. The Payout (Annuitization) Phase

In accumulation phase, you make payments while your annuity accumulates interest tax-deferred. The specific accumulation process may differ based on the type of annuity you possess.

Accumulation Phase Based on Type of Annuity

• With a variable annuity, the carrier will invest your premium in stocks, bonds, and other short-term money market products. These are referred to as “subaccounts,” which mirror mutual funds. The performance of these subaccounts will determine your rate of return.

• A fixed annuity guarantees that your investment will accumulate interest steadily, never dropping below a specified minimum.

• If you invest in an indexed annuity, your investment is tied to stock-market indices, like the S&P 500. No worries! Your contract offers a safety net with a guaranteed minimum interest rate, protecting you in case of stock market declines.

Annuity Payout (Annuitization) Phase

For income options, fixed and variable annuities have long been known to offer deferred income and immediate income. Deferred income offers the advantage of commencing at a future date, enabling the account value to grow tax deferred. On the other hand, immediate income guarantees payments that start either immediately or within a year of your purchase.

You have the choice to receive payments either for your entire lifetime or for a specified number of years. The payout of your annuity is determined by the performance of the investments underlying it. For variable annuities, or the payout option you select for fixed annuities. Make informed decisions to maximize returns and secure your financial future.

Systematic Withdrawals

When distributing funds through systematic withdrawal, you can withdraw the annuity as periodic taxable payments. The account will continue to accrue interest on any remaining funds until they are emptied.

Under the annuitization distribution plan, the annuity contract’s accumulated value becomes a series of regular payments for the annuitant’s lifetime or a set number of years. This is the point at which you decide the method for calculating your future payouts. To illustrate, here are a few examples:

Income for Guaranteed Period (also called Period Certain Annuity)

You are assured of a fixed payment amount for a designated duration, whether it be five years or 30 years. IIf you pass away during the specified duration, your beneficiary will receive the remaining payments for the guaranteed period.

Lifetime Payments

A lifetime guaranteed income payout without a survivor benefit is available. Depending on your investment amount and life expectancy, you can receive fixed or variable payouts. However, it’s important to note that all payments cease upon your death, resulting in no financial benefit for your heirs.

Income for Life with a Guaranteed Period Certain benefit (also called Life with Period Certain)

A combination of a life annuity and a period-certain annuity provides you with a guaranteed payout for life, along with a designated period. If, unfortunately, you pass away during the period specified, your beneficiary will receive the remaining payments for the duration of that period. For instance, a common arrangement is a life annuity with a period certain of 10 years. If you pass away after receiving payments for five years, your survivor will continue to receive payments for the remaining five years.

Joint and Survivor Annuity

By choosing a Joint and Survivor Annuity, your beneficiary will receive payouts throughout their lifetime even after your passing. This option is particularly favored among married couples.

It is important to consider that the ‘Joint and Survivor’ option provides a lower payout compared to the ‘Lifetime’ option. However, in the ‘Joint and Survivor’ option, the payout would continue after the passing of one spouse. Whereas, in the Lifetime option, the surviving spouse would not receive any payout upon the death of the other spouse.

Lump-Sum Distribution

An annuity, when distributed as a lump-sum disbursement, provides a single, taxable payment at once..

What Annuities Can Do for You

When it comes to financial planning, annuities can play a vital role. Depending on your retirement objectives and long-term goals, finding the right annuity may be the perfect fit for you.

• A variable annuity can provide guaranteed income and investment flexibility
• A fixed annuity with a guaranteed lifetime withdrawal benefit can offer you guaranteed income for life, starting when you’re ready to receive it.
• An indexed variable annuity can be customized based on your unique needs and circumstances
• A fixed indexed annuity can offer protection from market loss and opportunities for growth
• Create lifetime income and guaranteed growth without exposure to market risks and principal protection
• Offer flexible, tax-efficient investing
• Provide a standard death benefit to help provide a legacy for your loved ones

Being Well-Versed in Annuities

Congratulations! You are now well-versed in the ins and outs of variable, fixed, and indexed annuities. Armed with this knowledge, you can confidently navigate the selection process. Rest assured, there’s an array of options available to cater to your specific needs in virtually any circumstance.

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