The Indexed Annuity Versus The Variable Annuity
If you know you need to get an income from the money in your retirement accounts, then an annuity might be in your future. No other financial vehicle does what an annuity can do: it turns investments into paychecks. The problem is, which annuity is best?
It can be hard to figure out the advantages and disadvantages because professionals who sell annuities sometimes earn commissions on these products and that can sway their bias. They may not have access to certain types of annuities, and so they won’t offer them, or they might tell you that they are “bad annuities.” In this article, we will lay out the facts so that you can decide for yourself, which is better, the indexed annuity or the variable annuity? And what are the biggest mistakes that people make?
WHAT IS A VARIABLE ANNUITY?
A variable annuity is a type of deferred annuity, where you have to wait a while before you access the income. While you’re waiting, the idea is that the annuity will grow. One of the biggest ways that the variable annuity differs from the indexed (and fixed) annuity is the way it does this growing.
Variable annuities are invested in the stock market, and as such the people who sell them have their securities license. Because it is a market investment, the account value of a variable annuity can rise or fall in value. Even if you pay extra for growth guarantees, the actual value of your account may still fall.
Pros: It’s usually pretty easy to buy a variable annuity because they are sold by stock brokers, and the person who manages your retirement account can probably get you one. If you are familiar with how mutual funds work, then you will likely understand the investment component of a variable annuity. They might be appropriate for someone early in their working years who have already maxed out their 401(k) or retirement accounts and is looking for another place to grow their money tax-deferred.
Cons: Although easy to get, the variable annuity is one of the most expensive annuities you can own. Because they directly participate in the stock market, you’ll pay sub accounts fees and management fees just like you do in your 401(k), only there are even more fees with the variable annuity. These fees are assessed yearly, whether you gain money or not. Perhaps the most notable fee is the M&E risk fee, a fee that only the variable annuity charges. To guarantee the income with this type of annuity, you’ll most likely have to purchase a rider, often called a GLWB or guaranteed lifetime withdrawal benefit rider, for another fee.
Biggest Mistake: A lot of people get confused about the GLBW or income rider because this feature is often pitched to them by an annuity salesperson as a guaranteed rate of growth on their investment. People think they are getting a guaranteed rate, usually somewhere in the neighborhood of 6 to 8 percent. What they are really getting is a sub-account that grows at an accelerated rate for a fee. This sub-account is not the value of your actual account, which can still fall in value when the market drops. Furthermore, you may only access this money via the income payments.
WHAT IS AN INDEXED ANNUITY?
An indexed annuity is a sub-type of a fixed annuity. In fact, it’s often called a fixed- indexed annuity, or an FIA for short. Both fixed and fixed-indexed annuities are insurance products, and as such, your broker or fund manager may not be able to sell them.
These annuities grow your money using fixed vehicles to provide you with guaranteed minimum returns. As a deferred annuity, an indexed annuity gives you an element of growth by linking to an index. They earn limited interest based on the performance of a stock market index such as the S&P 500. The amount of interest you can earn is usually capped, typically somewhere between 5 and 10 percent, but your returns may be locked in for the year so that your account value won’t fall due to market loss.
Pros: Because a fixed-indexed annuity is more secure than a variable annuity, it’s one way to keep up with the rate of inflation while also protecting your retirement money. The FIA was designed to outpace fixed annuities earning 1 or 2 percent, and it can also solve the problem of income. A fixed-indexed annuity with an income rider, for example, can give you pension-like benefits plus the added bonus of a cash distribution to family members should you not use all of the money in the annuity.
Cons: Fixed-indexed annuities are often called complex because the interest on fixed-indexed annuities is typically limited in some way, even if the annuity is said to be “uncapped.” This might be difficult for some investors to grasp. The income rider benefits can also be complex, although they aren’t any more complicated than those offered by the variable annuity, and because there is no M&E fee with indexed annuities, they are typically much more cost-effective.
Biggest Mistake: Investors sometimes get into fixed-indexed annuities under the assumption that they will earn returns that compete with market investments. While indexed annuities can offer attractive returns, they weren’t designed to compete with market investments; they were designed to keep up with the rate of inflation (which averages 3.22 percent) while also providing a more secure place to grow your income funds.
We hope this comparison has been helpful to you. If there is still a question in your mind, feel free to reach out to one of our retirement planning experts. We’d be happy to get back to you, no strings attached. If you have an annuity that you’re considering and you want to have it tested against other annuities to find out which will pay you more income, fill out our simple form. We are happy to provide this service to at no cost.