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For many annuity shoppers, the choice comes down to two broad options: A fixed annuity versus a variable annuity.
- A fixed annuity offers a guaranteed interest rate and protects your principal from market downturns.
- A variable annuity allows you to invest in the market for higher growth potential, but it comes with the risk of losing value.
What makes sense for you will ultimately depend on your overall goal, like growth or safety, and your risk tolerance.
“The question of fixed versus variable annuities comes up frequently,” said Sarah Hedges, CFP®, CLU, ChFC, head of field management – East, for MassMutual. “To me, it really comes down to the risk tolerance of the buyer and where they are in age and life stage.”
Many people rely on a financial professional to help them understand the choice. To help that conversation, though, it pays to delve a little deeper into what each category of annuity does.
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There are other specialized types of annuities beyond these two broad categories, like income annuities and qualified longevity annuity contracts. But for the discussion here we’ll look at fixed annuities versus variable annuities. Another wrinkle is that some annuities can start paying immediately, while others can be deferred. A deferred annuity allows you to invest over time and receive payments at a future date. (Related: Types of annuities)
Fixed annuities and variable annuities are deferred. And any growth in both types of these investments is tax deferred, meaning you won’t owe taxes on earnings until you take withdrawals.1 (Learn more: How is annuity income taxed?)
What is a fixed annuity?
Since fixed annuities are deferred, you are investing money over time and receiving guaranteed income payments at a future date, such as during retirement.
Fixed annuities earn interest at a rate that is set by the insurer for that investment period, called the guarantee period and elected at issue. Essentially this allows a fixed annuity to provide a guaranteed return.
This category includes multiyear guaranteed annuities (MYGAs). This is an annuity contract issued by an insurance company that lets you lock in a guaranteed interest rate for typically two to 10 years.
In essence, fixed annuities are designed for a more conservative approach to growing some of your assets while avoiding the effects of market volatility. Along with their tax-deferred growth, fixed annuities always offer zero market risk with principal protection. But they have limitations on withdrawals and surrender periods, which can trigger charges if you withdraw too much too soon.
There is another kind of annuity in this category — a fixed index annuity. And while this deferred type of annuity also falls under the fixed annuity umbrella, it credits interest differently than a traditional deferred fixed annuity. The interest that may be credited is tied, in part, to the performance of a specific market index, such as the Standard & Poor’s 500 Index. It is not investing directly in the index. Fixed index annuities typically provide the potential for a higher index-linked interest than the guaranteed interest rate offered in a deferred fixed annuity — but they also present the risk that the contract owner might receive zero interest in a given year if the linked index experiences a flat or negative return. Plus, index-linked interest may be credited only once a year with an index annuity, versus daily with a deferred fixed annuity.
Also, the potential for a higher index-linked interest may be subject to a cap. That is, if the linked market index performs higher than the cap, your credited interest stops at that maximum limit. That’s the price you pay for the downside protection of your principal in a market downturn.
“Fixed annuities — and I use that as a broad umbrella term to include traditional MYGAs as well as indexed annuities and even income annuities — are more geared for conservative investors who value stability and safety while still looking for growth that outpaces other conservative investments, like certificates of deposit,” said Michelle Miller, external wholesaler for MassMutual Financial Advisors annuity regional sales division. (See: Conservative options for retirement: CDs vs. fixed-rate annuities)
What is a variable annuity?
Variable annuities are designed to provide market exposure. Their potential growth — and your potential future income — depends on market behavior, so while you might achieve greater gains than in a fixed annuity, you’re also exposing yourself to more risk, including the risk of losing value.
With variable annuities, you are still purchasing an annuity contract from an insurance company. But unlike fixed and income annuities, you’re responsible for deciding how the money you apply to the contract is invested — typically from among a variety of underlying funds or fixed account investment options provided by the contract.
With many variable annuity contracts, you can also make changes to how your contract value is allocated among the available investment options. That kind of flexibility can be particularly helpful as your risk tolerance changes over time or legacy plans develop. (Related: Understanding annuity death benefit protection)
Of course, just like with any other stock or market-related investment, there is risk of loss of value and past performance is no guarantee of future returns.
The difference?
What’s the difference between a variable annuity and a fixed index annuity? Downside protection. Fixed index annuities typically offer protection of your principal investment from negative market index performance. Variable annuities do not (unless certain riders are added at an additional cost). This can be an important consideration for those nearing retirement.
Keep in mind that the differences about principal protection discussed here pertain to market performance. Principal in an annuity can also decline because of other factors, such as withdrawals or the effect of fees for riders or such over time.
But in these considerations, it is important to take notice of a specialized kind of variable annuity: the registered index-linked annuity (RILA). RILAs combine features of traditional variable annuities and fixed indexed annuities by offering index-linked growth potential along with a defined level of downside protection. RILAs offer growth linked to market indexes (like the S&P 500) but include buffer and floor strategies to limit downside risk. RILAs are registered securities and carry investment risk, as they typically don't offer full principal protection for market downturns like fixed index annuities. They also may have caps on gains along the same lines as fixed index annuities or limits on gains over a specific period of time.
“Variable annuities, which I would use to cover RILAs as well as traditional variable annuities, are for more growth-oriented investors who are seeking market-like returns but would like some protection built in,” said Miller.
Annuity comparison
In the end, the choice between variable and fixed annuities comes down to the buyer. Variable annuities suit investors seeking market growth who can handle risk, while fixed annuities fit conservative savers wanting principal protection and predictable income. Some annuities — like fixed index annuities or RILAs — can offer a middle ground.
Also, variable annuities often carry additional fees, including investment management and optional rider charges, which can affect long-term returns.
So, if you’re considering an annuity, take a look at what kind of growth you’d like to see in your investment and how much risk you’re willing to accept in exchange for that growth. A financial professional can help you sort through the options.
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Frequently Asked Questions about fixed vs. variable annuities
Q. What is the main difference between a deferred fixed annuity and variable annuity?
A. A fixed annuity guarantees a set interest rate and protects your principal, while a variable annuity invests in market-based funds for higher growth potential but with the risk of losing value. The choice depends on your risk tolerance and retirement goals.
Q. What is the main difference between a deferred fixed annuity and a fixed index annuity?
A. Index-linked interest for an FIA is not guaranteed, while a deferred fixed annuity offers guaranteed interest.
Q. Is a fixed annuity safer than a variable annuity?
A. Fixed annuities generally carry less risk because they offer principal protection and a guaranteed interest rate, though they may offer lower growth potential. Variable annuities trade that safety for the chance of higher market-driven returns.
Q. How do I choose between a fixed and variable annuity?
A. Consider your risk tolerance, age, and whether you prioritize safety or growth. A financial professional can help you compare options and decide which annuity fits your retirement plan.
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