Differences Between Fixed and Variable Annuities

Annuities are one of the most powerful ways to plan for your retirement.

Despite some misconceptions about annuities, they are the only financial product that can guarantee you lifetime income once you stop working.

But there are many different types of annuities out there.

Unless you're a financial advisor or insurance expert, you might find it difficult to understand the differences between them.

In this article, we clarify the difference between fixed and variable annuities. We explain how they’re different, the advantages and disadvantages of each, and how you can decide between them.

How Do Annuities Work?

While annuity contracts can have any number of features, they all work in roughly the same way.

They’re a bit like a private pension that you fund yourself.

First, you pay a premium to a life insurance company. Then, the insurance company pays that premium back to you with any interest earned.

You can request periodic income payments or take the money as a lump-sum payment. While annuities are simple in principle, they can get somewhat complex when you think about all the different ways you can customize them.

But customization isn't necessarily a bad thing. Insurers like to offer products that appeal to different people with various financial circumstances and preferences.

The customization allows annuity purchasers (like you!) to decide which annuity product works best for them.

When we discuss the different types of annuities, we generally are referring to when the payouts begin and how rates are credited to you.

With an immediate annuity, you purchase the annuity and begin to receive money back almost immediately.

A deferred annuity has two phases: the accumulation phase and the payout phase.

The accumulation phase is a period of time when your money grows. Your funds have time to accumulate interest before they’re paid back to you. That means your account value increases, and you end up with more retirement income.

Annuities can also differ in how their crediting rate is calculated.

That’s where the difference between fixed and variable annuities comes in.

Note that we’re only discussing fixed annuities and variable annuities.

We will not be discussing fixed-indexed annuities in this article, but if you'd like to know more about them, check out our article on how annuities work.

Fixed Annuities

In a fixed annuity, the rate of return has a fixed minimum. That means that over the period of time you select, your fixed annuity interest rate will never fall below that minimum (although it may rise).

Fixed annuity owners can actually calculate exactly how much interest they’ll earn if they leave their money in the annuity over the term they choose.

So, for example, let’s say you buy the Canvas Future Fund with a 7-year term at the current crediting rate of 3.25%. You start with an initial premium of $250,000, so in 7 years, you know that your annuity will grow to over $310,000.

All fixed annuities have a contract minimum crediting rate but some also offer a higher rate for a certain guaranteed term.

This type of fixed annuity is called a multi-year guaranteed annuity. In the example above, the Canvas Future Fund has a 7-year term where the rate is guaranteed at 3.25% and then for the remainder of the annuity’s life, the minimum rate is 1%.

Advantages of Fixed Annuities

Fixed annuities are powerful tools because they provide a very low-risk way to grow your retirement savings and achieve guaranteed income when annuitized. Here’s a list of their advantages:

1. They offer a guaranteed income in retirement.
2. They are low risk because of their guaranteed minimum rate of return.
3. Their interest rates are much higher than other low-risk instruments like CDs.
4. Premiums grow tax-deferred, meaning you don't pay income tax on your earnings until you receive payouts in the future.
5. They typically have death benefit payout options available.
6. There are no contribution limits, unlike IRAs and 401(k)s.

Disadvantages of Fixed Annuities

Fixed annuities have a lot of benefits. However, there are some drawbacks to keep in mind.

These include:

1. Your money is somewhat illiquid. While you can withdraw from your annuity early, you may face surrender charges or tax penalties if you do.
2. Your interest rate stays fairly constant. Interest rates for fixed annuities don’t rise (or fall) with the stock market.
3. Fees. Some companies charge annuity fees for managing your fixed annuity. (Note that at Canvas, our annuities have zero commissions, account charges, or management fees.)

Variable Annuities

Variable annuities are a little more complex than fixed annuities.

They differ from fixed annuities in that the interest rate for variable annuities changes depending on the stock market and the investment portfolio you choose.

When you purchase variable annuities, you choose several sub-accounts to invest in. These sub-accounts are usually tied to mutual funds that have a stated investment objective. The rate of return on your annuity is directly tied to the performance of the investments you chose.

So, with a variable annuity, you do have investment risk. If the stock market booms and your investment choices appreciate, you could earn a higher rate of return than a regular fixed annuity.

However, if your investments don’t do well, you could earn no money at all and you could even lose money. Because variable annuities are a hybrid between insurance and investment products, they're regulated closely by both FINRA and the Securities and Exchange Commission (SEC).

Advantages of Variable Annuities

The advantages of variable annuities are:

1. Like all annuities, they offer guaranteed income in retirement. However, you can't be sure your funds will grow over time—remember, you can lose money with variable annuities.
2. You have the potential to earn a higher rate of return on your premiums than a fixed annuity (but you may not).
3. Like all annuities, your premiums and earnings grow tax-deferred.
4. There are usually death benefit payout options available for variable annuities.
5. Like all annuities, there are no contribution limits, unlike IRAs and 401(k)s.

Disadvantages of Variable Annuities

As with fixed annuities, variable annuities also have some disadvantages.

These include:

1. Interest rate volatility. Your earnings are tied to market performance. If your investments tank, you could end up losing money. If you’re nearing retirement age and you lose money, you may not have time for the stock market to rebound before you actually need to use your money.
2. There is a lot of risk because your annuity income depends on the performance of the stock market.
3. As with fixed annuities, variable annuities are illiquid. You can withdraw your money at any time, but you may face early withdrawal penalties.
4. Most companies charge management fees for managing the investment portfolio underlying a variable annuity. These are almost always higher than the fees for fixed annuities.

Variable Annuity vs Fixed Annuity: Which Is Better?

There are pros and cons to both types of annuities. Which one is better? It depends on your financial situation and how much risk you’re comfortable with.

When to consider a variable annuity:

• If you want the potential of earning a higher interest rate.
• If you're confident in your ability to choose successful investments.
• If you're comfortable with a high-risk investment option.
• If you’re okay with possibly losing money.

When to consider a fixed annuity:

• If you want a guaranteed interest rate.
• If you want to almost entirely eliminate your investment risk.
• If you enjoy the confidence of knowing your money will grow steadily over the period you select.
• If you like being able to calculate the future value of your retirement account.

Differences between fixed annuities and variable annuities:

Fixed Annuities Variable Annuities Interest Rate Guaranteed fixed rate for the term selected and will never go lower than the fixed minimum

In our opinion, fixed annuities are better for the average person looking for steady, guaranteed returns. Most people want to have some certainty that their money will grow over time. Fixed annuities provide that certainty. Because you could lose money with variable annuities, they don’t provide that same security.

We’re not alone in that opinion. Billionaire investor Ken Fisher is a notable critic of variable annuities. He is much more friendly towards fixed annuities.

Make Fixed Annuities Part of Your Retirement Plan

Annuities provide what everyone wants in retirement: financial security. They give you a guaranteed retirement income, supplementing your social security check and savings so that you can live your best life once you stop working. While both fixed and variable annuities can be great for retirement planning, fixed annuities are usually more popular—and for good reason!

They're less risky, they grow steadily, and eventually, they provide a steady stream of income.

Variable annuities are less certain—you’re placing your faith in the volatility of the stock market. If you’re currently planning for retirement, consider fixed annuities. Canvas offers fixed annuities that have some of the best rates in the business.

Have a look through our annuity products and see how your money could grow. And get in touch if you have any questions. Our friendly, licensed, and non-commissioned representatives are available to answer any of your questions.