Among the various kinds of annuities, which are contracts you sign with an insurance company to pay a premium for guaranteed income later, two of the most common are fixed and fixed indexed annuities. The former offers a fixed rate of return; the latter ties your rate to a market index to let you realize greater returns. Comparing the key differences between the two will help you determine which one might be suitable for your retirement saving strategy.
What is a Fixed Annuity?
A fixed annuity is a contract between a policyholder and an insurance company. In exchange for a lump sum or a series of payments, the insurance company provides a set amount of income starting at a future date. Even though there are many different types of annuities, fixed annuities tend to be more straightforward and easier to understand.
Essentially, you purchase an annuity and the money in the policy grows tax-deferred at a fixed rate. This phase is known as the accumulation phase. Then, the annuitization phase begins when you start to take money out of the annuity and receive payments, according to the terms of the contract. The rest of the funds in the account continue to grow tax deferred.
What is a Fixed Indexed Annuity?
With a fixed indexed annuity, investors receive a minimum interest rate over a certain number of years. The contract defines all terms. This type of annuity’s returns are usually based on the performance of an underlying index like the S&P 500. Purchasing a fixed indexed annuity allows the investors the opportunity to diversify their portfolio. It also gives investors the opportunity capitalize on a wide section of the market. Even though the benchmark does follow the index, you’re never truly exposed to the volatility of the stock market.
For example, let’s say you purchase an equity-indexed annuity. With this type of annuity, you may earn up to 80% of the returns of the S&P 500 over the past year. If stock prices dip, your annuity may pay a guaranteed percentage of between zero to 2%. It’s important to note, even if the stock market has a great year, you may only be able to earn as much as the capped maximum percentage, which is defined by the annuity contract.
Keep in mind, fixed indexed annuities are complex since they combine characteristics of a fixed annuity and a variable annuity. A fixed annuity offers a guaranteed return while variable annuities give the investors the opportunity to invest in assets of their choice. A fixed annuity offers security while a variable annuity comes with a higher level of risk.
The biggest difference between fixed annuities and fixed indexed annuities is how the insurance providers calculate interest. A fixed annuity offers a guaranteed interest rate for a specific amount of time. You can then exchange your annuity for another without any tax consequences if you find the rate of return is too small or the surrender period expires. Then, a new surrender period would apply to the new contract.
A fixed indexed annuity offers a guaranteed interest rate as well as additional returns if the stock market performs well. However, the tradeoff is that there is a lot larger surrender charge and the formula for calculating returns can often be extremely complex.
Which Annuity is Right for You?
Overall, a fixed annuity is a good option for a more conservative investor who doesn’t want to take on much risk but does want to achieve higher returns than a traditional money market or certificate deposit. Fixed indexed annuities might be suitable for an investor who still wants to minimize risk but wants the potential to earn a higher rate of return.
It’s important to note that annuities aren’t liquid assets. If you choose to withdraw your funds before the term of the annuity is up, you may have to pay a surrender fee. You may also have to pay a 10% penalty if you’re under 59 1/2 years old. This may be in addition to the taxes on your gains. Therefore, if you think you may need cash soon, you may not want to tie up all your assets in either kind of annuity.
Also, it’s important to note brokers may try to exaggerate returns to attract investors. FINRA warns that an annuity is only as good as the insurance company that backs it up. So, before you purchase either annuity, do the proper research. You will also want to understand all the benefits and drawbacks to each investment decision.
The Bottom Line
Fixed annuities and fixed indexed annuities offer a guaranteed rate of return. However, fixed indexed annuities provide the potential to earn a higher rate of return because they are tied to an index such as the S&P 500. Even though both investments have relative principal protection, they still come with a few disadvantages.