Fixed and variable annuities are types of deferred annuity contracts. With both account types, your premiums are invested for a number of years, after which you can make a lump sum withdrawal or convert the contract to an income stream. Despite the broad similarities there are different pros and cons to fixed and variable annuities.
In a fixed annuity contract your premiums are invested in interest generating accounts that contain bonds, commercial paper and similar instruments. Your returns are guaranteed either for a set period of time or for the duration of the contract. You already know how much you should earn over the course of the annuity term when you initially invest your money. Variable annuity contract premiums are invested in mutual funds. Your returns are based on the performance of these funds, so you may gain or lose money over time. Most contracts include minimum growth guarantees, but the guarantees only apply if you convert the mature contract into an income stream rather than taking the cash as a lump sum.
Neither variable nor fixed annuities are federally insured, but state operated insurance guarantee funds protect your investment in the event that the annuity firm goes bankrupt. Coverage levels vary between states, but fixed annuity premiums are guaranteed as long as your account value remains below the coverage limit. In contrast, variable annuities offer no actual principal guarantees because the underlying mutual funds fluctuate in value on a daily basis. Therefore, you encounter the same kind of principal risks that you would experience if you invested directly in mutual funds.
Deferred annuities usually have term times of five years or more. In most instances, you can make withdrawals of principal from a fixed annuity without incurring a penalty. You may pay surrender fees if you withdraw your earnings before the contract reaches maturity. The surrender fees are often higher and apply to withdrawals of both principal and earnings on variable annuity contracts. On both types of annuities, you also have to pay income tax and a 10 percent tax penalty on withdrawals of tax deferred earnings that you make before reaching the age of 59 1/2.
Variable annuities offer you the potential for unlimited growth since there are no caps on rises in mutual fund share prices. With a fixed account, your returns are limited by the contract's interest rate. During inflationary cycles, returns paid on long-term fixed accounts may lag behind inflation. This means you lose spending power even though you do not lose any actual cash. Investment analysts describe this potential danger as inflation risk.
Generally, you do not have to pay any fees when you invest in a fixed annuity so these contracts are usually fee free if you do not make any premature withdrawals. In contrast, you have to pay annual operating fees when you invest in a variable annuity. These fees cover costs associated with the underlying mutual funds and the cost of optional riders such as minimum income guarantees. On an annual basis, variable annuity fees often amount to 3 or 4 percent of the contract value.