As you look toward retirement, you may consider different strategies to ensure a steady stream of income. Annuities are one way to accomplish that goal. These financial products usually require you to make a lump sum or series of contributions, then provide a schedule of payments over a determined time period. After hitting record-high sales in 2022, annuity sales reached $92.9 billion during the first quarter of 2023, a 47% increase from the prior year, according to data from LIMRA.
Two common types of annuities are fixed and variable. While they share some features, they are also different in certain aspects. You’ll want to know what’s involved with each before making a purchase.
When comparing fixed and variable annuities, understand:
- What is a fixed annuity?
- Pros and cons of a fixed annuity.
- What is a variable annuity?
- Pros and cons of a variable annuity.
- Which annuity is best for you: fixed or variable?
What Is a Fixed Annuity?
A fixed annuity is a financial product that guarantees a set interest rate over a predetermined period of time. “This is essentially synonymous with a pension fund in the way it functions,” says Joseph Favorito, a financial planner and managing partner at Landmark Wealth Management in Melville, New York. “You fund the contract with a pool of money, and the insurance company will do an actuarial calculation on how much they can pay you for a period of time.”
You might opt for lifetime payments or choose a set number of years. Some fixed annuities are immediate, meaning you begin to receive checks right away. Others have a deferred feature and will begin payments after a period.
Pros of a Fixed Annuity
Some savers appreciate the balance that a fixed annuity can provide in a portfolio. “Fixed annuities are generally better as conservative income tools,” says Sherman Standberry, a certified public accountant and managing partner at My CPA Coach in Atlanta.
Pro: More Security
If you are looking for something you can depend on, you may be interested in this product. “Fixed annuities are the safest type of annuity contract in the market,” says Thomas Brock, a CPA and expert contributor for Annuity.org. “They offer guaranteed, fixed rates of interest and appeal to highly risk-averse investors that are uncomfortable with volatility.”
Pro: Low Maintenance
If you want to avoid annual reviews and changes, a fixed annuity could be a good fit. These products provide an ongoing income stream that will be consistent. “They serve as a set-it-and-forget-it financial product, requiring no ongoing management or decision-making on your part,” Standberry says.
Cons of a Fixed Annuity
Even though fixed annuities are relatively straightforward, there are also disadvantages to these products. You’ll want to talk to your household members before getting one to make sure they are on board.
Con: Lower Returns
Since they are considered a low-risk and safe product, you may find that the rates attached to a fixed annuity are lower than you’d like. As the years go by, this steady income stream might get stretched, especially if prices rise and your income remains the same.
Con: Less Flexibility
If you opt for a fixed annuity, you’ll likely find that you’re not able to make changes. If, for example, you want to access more funds 10 years into your contract, you could face steep penalties.
What Is a Variable Annuity?
Unlike the set rate of a fixed annuity, variable annuities have variances tied to them. “All variable annuities are issued with some form of a subaccount attached that is linked to investment performance,” Favorito says. The return you receive on your funds could vary based on the market.
When you purchase a variable annuity, you’ll often be able to choose between an immediate or deferred option. A variable immediate annuity will start to send payments to you at the onset of the agreement. A variable deferred annuity will deliver funds after an established timeframe.
Pros of a Variable Annuity
If you’re interested in a product that is tied to the market and its performance, a variable annuity could be an option. There are a couple of advantages that you’ll frequently find in this type of retirement strategy.
Pro: Higher Potential Returns
If your investments perform well over time, you could end up with higher returns than you would with safer vehicles. For those who want a diversified portfolio, adding a variable annuity to other lower-risk products could be an option.
Pro: More Choices
If you’d like to decide where to place your funds and what investments to make, a variable annuity will allow you to choose from a selection. You could speak to a financial advisor to help you make decisions related to the annuity.
Cons of a Variable Annuity
Some savers find variable annuities to be less attractive than other investment choices. You’ll want to think through the drawbacks to make sure you understand what you’re committing to before buying one.
Con: Greater Risk
“Variable annuities are the riskiest type of annuity contract because they entail investment positions in volatile financial securities, such as stocks and bonds,” Brock says. “This exposes investors to the very real possibility of losing principal.”
Con: More Complexity
Variable annuities typically have fees attached that cover the management of the investments, which could cut into your returns. In addition, you will often have more choices to make regarding how funds are invested.
Deciding if a Fixed or Variable Annuity Is Best for You
As you plan for your retirement years, you may want to consider your tolerance for uncertainty. “If you are risk-averse and desire predictable income, a fixed annuity may be better,” Standberry says. “If you’re looking for a higher return potential and can take market volatility, a variable annuity might be suitable.”
You’ll also want to consider the impact of inflation, as a lower fixed rate might not be enough to keep up with rising costs over time. “Variable annuities offer a chance to beat inflation, while you may need to buy additional options for a fixed annuity to do so,” Standberry says.
Both types of annuities offer tax-deferred growth, but you can expect to pay taxes at the time of withdrawal. You’ll want to look at your current income and expected retirement budget to help you plan. You may find that setting aside funds now will create tax advantages later when you’re in a lower income bracket.
