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As you approach retirement, you may examine various techniques to ensure a consistent source of income. Annuities are one approach to achieving this goal. These financial products typically demand you to make a single or series of contributions before receiving a payment schedule over a certain period of time. Annuity sales totaled $92.9 billion in the first quarter of 2023, up 47% from the previous year, according to LIMRA data.

There are two types of annuities: fixed and variable. While they share some characteristics, they also differ in certain ways. Before you make a purchase, you should understand what is involved with each.

Annuities are used by some investors as a retirement planning tool and a source of guaranteed income. While there are many different forms of annuities, two of the most common are fixed and variable annuities.

Here’s an overview of these two categories to assist you in determining their suitability for your own financial strategy.

What Is a Fixed Annuity?

A fixed annuity is a contract between the policyholder and an insurance company. A policyholder will make a lump sum payment or a series of payments in exchange for a guaranteed amount of income starting on a certain date. Essentially, when a policyholder buys an annuity they purchase future income.

Generally, fixed annuities are the easiest annuities to understand. When you purchase a fixed annuity, the money in the annuity grows tax-deferred with a set interest rate also known as the minimum credited interest rate. This period of time is also referred to as the accumulation phase.

When you start withdrawing money from the annuity, the annualization phase begins. The insurance provider will begin to make payments to you. These payments are carefully calculated by the terms of the annuity contract. Meanwhile, the remaining balance of the contract will continue to accumulate tax-deferred growth.

  • A life insurance policy is an example of a fixed annuity by which an individual pays a fixed amount each month for a pre-determined time period (typically 59.5 years) and receives a fixed income stream during their retirement years.
  • An immediate annuity involves an individual making a single premium payment, say $200,000, to an insurance company. They then receive regular payments immediately, for example $5,000 per month, for a fixed time period thereafter. The payout amount for immediate annuities depends on market conditions and interest rates.

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?

With variable annuities, policyholders can choose from a number of investment opportunities. Variable annuities have two components: the principal and the return. The principal is the amount the policyholder pays into the annuity. The return is the income the policyholder makes through their investment selection. Since returns may fluctuate, payments may vary as well.

Read Also: The Pros and Cons of Investing in Variable Annuities

When you reach retirement and want to begin receiving your payments, you must annuitize your contract. When an investor does this, their payments begin and the investment stops earning returns. However, once you reach the payout phase you may not be able to withdraw more than your regularly scheduled payments.

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.

Generally speaking, fixed annuities are less risky than variable annuities. Fixed annuities offer a fixed interest rate. Market volatility or company profits don’t affect the interest rate on a contract. For conservative investors who seek stability and safety, a fixed annuity might be a better investment option. Knowing that your payments will never fluctuate or vary may put a conservative investor’s mind at ease.

However, since fixed annuities are less risky than variable annuities they tend to have less investment flexibility or opportunity for growth. With variable annuities, you can invest in a variety of securities such as stocks and bonds to achieve your desired return. The stock market tends to impact a variable annuity’s value. Policyholders should select investments that coincide with their risk tolerance and time horizon.

For investors who have longer time horizons and are comfortable with market volatility, variable annuities may be a better option. They tend to keep pace with inflation and help investors reap higher gains over the longevity of the contract.

All annuities have contract limitations and fees. They also include charges such as mortality and expenses risk, investment management fees and administrative fees. There are additional charges for some optional benefits. Since insurance companies provide annuities, they are not backed by the FDIC or other federal agencies. Any claims the insurance provider makes are contingent on the financial strength of the company and the ability of the company to pay its claims.

Therefore, before you decide to purchase an annuity, make sure you understand the ins and outs of the contract. Fixed and variable annuities can help policyholders generate extra income. However, there are other options, such as contributing to a Roth IRA, which may make more sense in some financial situations. So, whether you’re considering a fixed or a variable annuity, it’s wise to partner with a financial advisor who can help guide you in making the most suitable investment decision.

Which Type of Annuity is Best?

A retirement annuity can provide a guaranteed stream of monthly payments for the rest of your life. Many retirement experts recommend purchasing a retirement annuity from an insurance company if other sources of guaranteed income, such as Social Security and pension payments, are insufficient to cover your basic living expenditures throughout retirement.

The potential advantages:

  • A lifetime payout option means that you can’t outlive the money, regardless of how long you live or what happens in the stock market.
  • Your investment is protected from other dangers, such as losing the money to fraud, unscrupulous advisors and bad investment decisions as you get older.
  • Payments are generally higher than what you could expect from other low-risk investments, such as certificates of deposit, money market accounts or bonds.
  • You may be able to take more risk, and potentially get better returns, from your remaining investments since your basic living expenses are covered.
  • State guaranty associations protect annuities against insurer insolvency, typically up to certain limits (usually $100,000 to $300,000 for each annuity owner).

The potential disadvantages:

  • You need a relatively large sum of money, roughly $100,000 for each $500 monthly payment starting at age 65.
  • You typically have to commit the money up front and can’t dip into it later if you have an emergency.
  • After you die, your heirs may or may not get a check — it depends on the options you choose.
  • If interest rates are low when you purchase, your payout will be less than what you would get if you purchased the annuity when interest rates were higher.
  • To make sure your payments are truly guaranteed, you’ll need to choose a financially strong insurance company and to understand how your investment is protected in case the insurer goes under.

Annuities come in a variety of formats, but for most retirees, the best option is a single premium instant annuity, also known as an immediate fixed annuity. These annuities provide monthly payments, which often begin immediately after they are purchased with a lump sum payment.

This sort of annuity has no investment component; the payments remain constant independent of what occurs in the stock market. In contrast, variable annuities have a value that fluctuates based on the performance of the investments chosen by the investor.

The monthly payment largely depends on the age and gender of the people buying the annuity:

  • A single man, age 65, who invested $100,000 in an immediate annuity could receive $529 a month, according to Charles Schwab’s income annuity estimator.
  • A woman the same age would receive $501 (the smaller amount reflects the woman’s longer life expectancy).
  • If they were a couple buying the annuity together, the monthly payment could be $438 if they chose the “joint life” option that pays out until the second person dies.

The life expectancy of two people is longer than any single life expectancy. While the life expectancy is 84 for the male and 86.5 for the female, there’s a 50% chance that one of them will live past age 92, according to the Society of Actuaries.

Monthly payouts can be higher if you start the annuity when you’re older or if a couple chooses a reduced payment after the first person dies, says Christine Russell, senior manager of retirement and annuities at TD Ameritrade. Payments may be somewhat smaller if you choose any of the add-on guarantees commonly offered.

You could, for example, opt for “joint life with 10 year certain.” You and your partner would receive the income during your lives, but if both of you die within the first 10 years, your beneficiaries would receive the remaining income payments until the end of the 10-year period. Another common option is a cash refund, which typically gives your heirs a lump sum equal to your original investment minus any of the payments you received.

Many immediate annuities also offer some kind of inflation protection. This option tends to make the initial payment significantly smaller, although the checks will rise over time.

The inflation adjustment can be helpful if you expect to live longer than average, retirement experts say. But you already have some inflation protection with Social Security, which has cost-of-living increases built in, Russell notes. Also, spending typically drops as people age and become less active, although health care costs may increase spending toward the end of life.

Another option for people who want to protect against inflation or benefit from higher interest rates is to “ladder” their annuity purchases. That means taking your lump sum and using a portion of it to buy an annuity every few years. If you have $300,000, for example, you might buy a $100,000 at the start of retirement, another one at 70 and a third at 75.

How to choose an annuity

You should get quotes from at least three insurers before choosing an annuity since payout amounts and options vary. You also may want to buy annuities from more than one company, depending on your state guaranty association’s insurance limits. If your state protects only $100,000, for instance, you could buy $100,000 annuities from three different companies to stay within those limits.

Even though this insurance exists, it’s no substitute for making sure you buy annuities only from financially strong companies. Insolvencies take time to resolve and your payments could be held up for years.

“You want to be sure that the company is well off enough financially and strong enough financially that they can make the payment long term to you,” Russell says.

Check the insurer’s ratings with one or more rating agencies (A.M. Best, Fitch, Moody’s and Standard & Poor’s) — an “A” rating indicates the company is financially strong enough to be around as long as you need it.

Bottom Line

Annuities are appropriate financial products for individuals seeking stable, guaranteed retirement income. Because money put into an annuity is illiquid and subject to withdrawal penalties, it is not recommended for younger individuals or for those with liquidity needs. Annuity holders cannot outlive their income stream, which hedges longevity risk.

An annuity is a financial contract between an annuity purchaser and an insurance company. The purchaser pays either a lump sum or regular payments over a period of time. In return, the insurance company makes regular payments to the annuity owner, either immediately or beginning at some point in the future.

An annuity can be fixed, variable, or indexed to an equity index such as the S&P 500 index.

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