Fixed vs. Variable Annuity: Which Is Best? (2024)

Annuities can help you build a predictable stream of income for retirement. Two of the more popular types, fixed annuities and variable annuities, share similar names but operate quite differently, and each is better suited to a different type of retirement investor. Here’s what you need to know to decide between a fixed vs variable annuity.

How Do Annuities Work?

Before getting into the weeds of fixed vs variable annuities, let’s understand how an annuities work in the first place. Annuities are insurance contracts that guarantee regular income payments in the future, in exchange for payment(s) now. Crucially, all annuities help prevent you from outliving your savings by “insuring” that you’ll receive X amount in regular payments for Y years.

The period when you make contributions to an annuity is called the accumulation phase. You can add funds to an annuity either gradually over time or in a single lump-sum payment. When you begin to receive payments from your annuity contract, you’ve entered the distribution phase.

When you open an annuity, you need to choose when you want payments to begin and how many years you want those payments to last. The insurance or financial services company issuing your annuity calculates the value of your monthly payments based on much you’ve contributed and how long you want the payments to last.

What Is a Variable Annuity?

With a variable annuity, your account balance and your payments fluctuate based on the performance of markets. For that reason, it’s probably easiest to think of a variable annuity as being like an individual retirement account (IRA).

Both a variable annuity and an IRA are retirement savings accounts that offer tax-deferred growth for your investment. When you start receiving payments, you pay income taxes at your marginal rate. Variable annuities are notable because they let you make unlimited annual contributions to a tax-advantaged account, whereas IRAsand 401(k)s have strict annual contribution limits. They may also offer attractive add-on features, like death benefits, that traditional retirement accounts don’t have.

Variable Annuity Rates

A variable annuity’s rate of return is dictated by the performance of the investments in its portfolio. Most variable annuities offer an array of subaccounts, which work like mutual funds and offer a mix of component investments. You get to choose which subaccounts you prefer, letting you build a portfolio that’s as aggressive or conservative as you like.

Benefits of Variable Annuities

You might consider getting a variable annuity for a few reasons:

Maximizing tax benefits. If you’re trying to save a lotfor retirement, you may have maxed out your workplace retirement plans and IRA. You might turn to a variable annuity to lock in even more tax-advantaged investment growth.

Potential upside. Variable annuities allow investors to accelerate the growth of their holdings via the stock market gains during the accumulation phase, potentially increasing their future income payments during the payout phase.

Lifetime income. Variable annuities allow investors to stretch their accumulated earnings to last a lifetime.

Guaranteed death benefit. Your survivors may receive a guaranteed payout if you die before your contract’s distribution phase and you purchased this type of rider. And like all annuities, your beneficiaries will be able to work directly with the issuer outside of probate to receive their survivor’s or death benefit. There’s no waiting on slow probate courts to get your savings into the right hands.

Disadvantages to Variable Annuities

With all their benefits, there are still reasons why you might not opt for a variable annuity.

Relatively high fees. Annual fees for variable annuities average 2.3% of the contract value. Additional riders can make fees even higher. This means money invested in comparable accounts outside of an annuity might offer drastically better returns.

Unpredictable returns. Fluctuations in the stock market could mean your investment doesn’t return what you thought it would, and your portfolio could lose value.

Surrender Fees. If you need to tap into your annuity funds early, you might face hefty penalties, called surrender fees. You could also be subject to an IRS 10% early withdrawal penalty if you withdraw funds before age 59 ½.

What Is a Fixed Annuity?

A fixed annuity guarantees an investor a fixed return on their investment. Considered a lower risk product than variable annuities, fixed annuities help investors protect their capital and receive income payments from their retirement savings while avoiding the rollercoaster of the stock market.

Fixed Annuity Rates

Unlike a variable annuity, where your rate of return depends on market performance, fixed annuities offer a fixed rate of return for the duration of the contract. Insurance companies pay these returns from the proceeds of their internal investment portfolios, which usually invest in low-risk investments like government securities and corporate bonds.

Fixed Annuity Benefits

• Guaranteed rate of return.You’ll be protected from the stock market’s volatility and still earn a reasonable return on your investment.
• Clarity. Because they contain fewer moving parts, fixed annuity contracts are often easier for investors to understand and avoid potential surprises after purchase.
• Easy budgeting. Because you know the exact payout amounts you will receive over the life of the contract, you can budget for your retirement with greater accuracy.

Fixed Annuity Disadvantages

• Limited returns. Rates for a fixed annuity might be better than what you’d get from a certificate of deposit or high-quality corporate bond, but they’re generally a fraction of stock market returns. And once you’re locked into a fixed annuity contract, you won’t be able to benefit from prevailing interest rate increases.
• Exposure to inflation. Fixed rates of return mean there’s no guarantee that your investment will keep up with inflation. Cost-of-living riders are available, but the additional fees may wipe out any gains. If you get a COLA rider, your initial distributions will also be less than they would be without one.
• Potentially high fees. While variable annuities offer more riders, and higher fees, riders such as long-term care and death benefits for your heirs can quickly increase your fixed annuity annual management fees.
• Surrender fees. As with variable annuities, you’ll face penalties if you need to withdraw your funds before the end of the surrender period. These can be as high as 9%—plus you’ll face an additional 10% penalty from the IRS if you’re under 59 ½.

Fixed vs Variable Annuity: Which Should You Choose?

While both variable annuities and fixed annuities offer benefits, there might be cases where one is more appropriate.

“Fixed annuities are a better choice for someone who has a low tolerance for risk,” says David Clausen, a certified financial planner (CFP) and wealth management advisor with Northwestern Mutual. “In today’s low interest rate environment, we are seeing people have a difficult time constructing a bond ladder that provides them the income they need without taking on significant credit risk or burning through principal.”

For those willing to tolerate more risk in their retirement funds—or those who want to save a lot for retirement—variable annuities might be the right choice.

“Variable annuities can be a viable solution for those who are willing to stay invested in stock-like markets, but need guaranteed income, living benefit or death benefit tied to their annuity to help them achieve their financial goals,” says Brady Kirkpatrick, a CFP with CenterPoint financial Group, Inc. “For example, some variable annuities have a living benefit attached to them where you can still take some income from a minimum benefit if the markets are down significantly, preventing you from withdrawing principal.”

When deciding between these types of annuities, though, focus on your own tolerance for risk and what blanks you need to fill in in your retirement plan.

“The primary questions to ask when deciding which type of annuity a client should use center on their tolerance for risk and the role that other assets are playing in their plan,” says Clausen. “Often annuities are used to supplement the planning already in place and to fill in gaps in the plan. Identifying those gaps is a great first step.”