Variable Annuities Vs. Index Annuities

Well-chosen annuity products can contribute to a comfortable retirement.

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For investors who have maximized their individual retirement account or 401k contributions, annuities can offer another path to tax-sheltered growth. Fixed annuities are simple contracts, with the issuer paying a guaranteed minimum return during the investment period and guaranteed payouts at maturity. Index and variable annuities are invested more aggressively and offer the opportunity to earn larger returns.

Annuity Basics

Permanent life insurance policies have always provided an opportunity for investment growth. Annuities are built on the same basic structure but are overhauled to function primarily as an investment. Growth within the contract is tax-sheltered until withdrawals begin, at which point the gains are taxed as ordinary income. Classic fixed annuities share in the insurer's overall investment pool, which is stable but conservatively invested and provides modest returns. Index and variable annuities were created to give the insurance industry an investment vehicle that could compete more effectively with mutual funds and other products.

Index Annuities

Index annuities, as the name suggests, are built around an investment portfolio that tracks a major financial index such as the Standard & Poor's 500. This strategy provides a clear benefit to both the insurer and the client. For the insurer, index annuities provide competitive returns with minimal management from its investment staff. For clients, the broad-based equity portfolio provides returns that typically outstrip the insurer's in-house portfolio while providing a diversified investment in the country's largest and most stable companies. Index annuity contracts typically provide a guaranteed minimum return, protecting buyers in case markets are down when they begin drawing an income.

Variable Annuities

Variable annuities are most like investing in other vehicles. They place your money in a portfolio of mutual funds, exchange-traded funds or even the insurer's in-house fixed investment account. You can change your portfolio within the annuity, either shifting your asset distribution over time or simply dumping underperforming investments in favor of better ones. The value of your annuity rises and falls with the markets, providing the opportunity for higher gains but also the risk of losses. Most variable annuities insulate investors from the possibility of loss by providing a guaranteed minimum return.

Potential Downside

Variable and market annuities sound attractive, shielding investors from downturns while still allowing them to share in market gains. Payouts can be taken for life, eliminating the risk of outliving your investments. However, those benefits come at a cost. Variable and index annuities have higher costs and fees than comparable investments outside the annuity, because they charge a second set of management fees beyond the underlying investment's own cost structure. They're also underwritten like an insurance policy to calculate your life expectancy for payment purposes. These costs are taken from your investment and can sap your returns. If you need to recover your money prematurely, you might face stiff surrender charges.