Fixed Annuities and Variable Annuities: Not a One-Size-Fits-All Product

Fixed annuities and variable annuities can be a pretty divisive topic amongst financial professionals. Well kinda. Financial professionals and financial advisors with securities licenses don’t debate as much with each other as we do with insurance professionals.

If you are reading this article, you are probably wondering about annuities. Maybe you have been pitched an “investment” that cannot lose value. Maybe a financial advisor has suggested a variable annuity. 

Annuities can be confusing, but let me help you out because they aren’t as complicated as they may seem. And it is really important for you to know the difference between fixed annuities and variable annuities in order to make good financial decisions. So let’s get started.

(1) What Are Fixed Annuities?

Fixed annuities are insurance products. They are not investment products by definition. A fixed annuity gives the buyer a specified return on the money put into the annuity for a specified period of time all the while getting tax deferred growth. (Meaning that the buyer doesn’t pay taxes on any growth until it is taken out.)

The time frame that an annuity (fixed or variable) will pay out can vary. It can be for as short as 5 years and it can also pay out for the entirety of one’s life.

The word fixed is important when understanding what a fixed annuity is. The rate of return on the annuity will be the same (AKA, fixed) for the entire life of the contract.

A overly simple example might be something like this:

Mike puts $100,000 into a fixed annuity. His payout is 2% for 25 years. That means that he will get a check for $2,000 per year (or $166.67 per month) for 25 years. (Without taking into account any fees, charges, etc. to make it simple.)

They are not investments.

One of the most important differences between fixed annuities and variable annuities is that as stated before, fixed annuities are NOT investments. To be an investment, there has to be a chance of losing money. And there is no chance of losing money with these products.

Your bank account works similarly. Because a bank account will not lose money, it is not an investment.

You might be thinking, “I don’t really care if it is an investment. So long as it doesn’t lose money, I like it!” And that is a reasonable thought.

But the problem is that these products are often sold as if they are investments when they are not. 

To sell a fixed annuity, one does not have to have a securities license. The salesperson only has to have an insurance license. This is because they are insurance products.

A true financial advisor (or someone with a securities license) will not put you in a fixed annuity unless you are in a very specific place in your investment journey.

The only time that a person should think about this product is once their retirement account(s) are completely maxed out, IRAs are maxed out, and Roth IRAs are maxed out.

Often, insurance salesmen don’t know this (because they are not investment advisors).

They have high fees.

Fixed annuities have several fees associated with them that other investment products do not (at least for the majority of other investment products).

The fees can consist of:

1. Commission: Up to 10% of what you invest can be given to the salesperson.
2. Underwriting fees: Because this is an insurance contract, there are underwriting costs.
3. Fund Management: Because the funds that you deposit are invested by the insurance company, the fund manager has to get paid.
4. Penalties: If you are under 59 ½ and withdraw money you will likely be penalized (much like investment accounts.)
5. Beneficiary taxes: If you happen to have an annuity that will pass to your heirs then they will be taxed on all gains (unlike an investment).

The money can be gone when you die.

There are several different ways to structure the contracts for these products. But most of the time they are structured in a way that your heirs will not get any money.

For example, Edna opens a fixed annuity with $300,000 that will pay her $500 per month for the rest of her life. After she has the annuity for 10 years, she dies. The rest of the money that she deposited into this product goes to the insurance company and not to her family. Even though she only received $60,000 back.

Yes, there are ways to structure these contracts to avoid that, but it will come at a cost. And the cost will be an even lower rate of return.

They have low rates of return.

This is arguably the second leading problem with fixed annuities. They have a HORRIBLE rate of return. Currently (February 2022) rates are around 3.25%. Compare that to the S&P 500 rate of return for 2021 of 26% or even a more average rate of return of 8-10%, fixed annuities have a HORRIBLE rate of return.

Why do they have such a low rate of return? Because they are guaranteed. 

That is the trade off. The buyer trades any uncertainty in the market and the possibility that the market will decline for a guaranteed rate of return. That is the opportunity cost of a fixed annuity.

In other words, fixed annuities trade an average rate of return of 8-10% but with the possibility of sometimes having a negative rate of return for a guaranteed small rate of return no matter what.

The problem is that the buyer then misses out on the gains that the market has in most years to protect themselves from the occasional market decline.

There is a surrender period.

A surrender period is a time frame at the beginning of the fixed annuity that you CANNOT cancel it. You have to leave it in place for a specified period of time. 

This time frame can vary from contract to contract. 

I have seen it for as little as 3 years and as long as 15 years. 

If you were to cancel your fixed annuity during that time you would be hit with penalties and fees. These typical surrender charges are about 10% and drop periodically the longer that you have the contract.

The Largest Risk: Inflation

This is by far the largest risk that someone takes on with a fixed annuity. 

Remember, that the rate of return with these products is guaranteed for the life of the contract. 

The problem is that it is not indexed to inflation. 

Think about it. Say someone took out a fixed annuity for $500,000 in 1990 that would pay them 4% every year until they died. That means that they would be paid $1,666.67 per month forever. 

That wasn’t bad for 1990. But it is bad now.

In 1990 the average rent payment was $447. Which would be about 26% of that annuity.

By 2020, the average rent was $1,104. Which would be about 66% of the annuity.

A loaf of bread in 1990 cost about $0.75. In 2020 it was about $2.20.

A gallon of gas in 1990 cost about $1.15. In 2020 it was about $2.35. 

You get the picture. 

Inflation will eat away a fixed annuity over time.

(2) What are Variable Annuities

There are a lot of differences between fixed annuities and variable annuities. But one of the biggest is that variable annuities work pretty much the same way as most other retirement accounts. The main difference is that any kind of an annuity (fixed, variable, or equity indexed) is an insurance product. It is not technically an investment product. But there are a few differences. So let’s point out the different characteristics of how they work.

Deferred Taxes

One of the largest benefits of variable annuities is that they have deferred taxes. Because they are a retirement product, you will not have to pay taxes on the money until you retire. In this way, they work the same as a 401k or other retirement plan.

Invested Money

When you put money into a variable annuity, that money will be invested. The money that is invested is done so in what is called a “separate account”. The separate account is basically a pool of money that the insurance company has that invests your money. The separate account is much like a mutual fund. It is important to note that not all of the money that you deposit into the annuity will be invested. Out of the money that you deposit there will be fees, commissions, operating expenses for the insurance company, etc.

Also, because the money is invested, that means there is a chance for loss. And anytime that there is a chance for loss of your money, the transaction has to be through an actual financial advisor. Someone who only has an insurance license cannot sell variable annuities. They must be sold by someone who has a securities license.

Surrender Charges

This is one of the biggest complaints of variable annuities. They typically have surrender charges. This means that you MUST leave your money in the product for a specified period of time or you will be charged a penalty. 

Surrender charges and lengths of time vary by the policy. I have seen them as short as 3 years and as long as 15 years! They typically have a decreasing fee structure to them. Meaning that each year that you leave the money in the variable annuity, there is a smaller and smaller surrender charge imposed on you for pulling the money out. 

Here is an example: Nancy deposits $10,000 into a variable annuity that has a decreasing surrender charge fee schedule that lasts for 10 years. Here is what it would look like if she pulled her money out of the variable annuity for each year.

High Fees

One of the biggest knocks about annuities in general (variable annuities included) is that they have high fees. 

On average, fees for variable annuities are about 2.3% per year. Compare that to a 401k, which averages about 1%.

These fees generally include (but are not limited to):

1. Commissions (we’ll get to that soon)
2. Administrative fees
3. Surrender charges
4. Mortality expenses
5. Investment expenses
6. Misc. fees

High Commissions

First of all, let me say this: There is nothing wrong with giving someone a commission. If that person has sold me something and served me in a professional way and has listened to my needs and done their best to meet my needs, I have no problem paying a commission. 

However, the commissions for variable annuities are REALLY high. They pay commissions of up to 8% of the contract value PLUS an annual trail commission that is usually around 1% each year. 

This will decrease the amount of money that you have in the investment to start with. And pair that with the surrender charges that you would have to pay if you got out of the contract early, it will take you years to break even. And you might not ever recoup the commission and high fees of the product.

No Maximums (Unlike Other Retirement Plans)

One of the really nice things about variable annuities is that there are no annual maximums on variable annuities. This is one of the largest benefits that people see with these products. 

Mostly people who have already maxed out all other retirement accounts and want the tax deferred growth of a retirement account look to variable annuities to fulfill that need.

Here is a list of the annual maximums that you can put into a given retirement account in 2022:

Gains Taxed at Ordinary Income

When you retire, there are three main ways that your money will be taxed.

1. It won’t be (Roth contributions)
2. Capital gains taxes (Non-retirement accounts that you have had for more than 1 year)
3. Ordinary income

When you retire, it is likely that you will have some of your income taxed at each of these levels. 

But with variable annuities, they will be taxed at ordinary income. Yes, you will have tax deferred growth, but you will also pay for that growth with taxes just like you would with a 401k, traditional IRA, or 403b.

Once you have maxed out all of your retirement options, it might be better for you to simply invest into an after-tax brokerage account instead of a variable annuity. That way your growth will be taxed at capital gains (for most people is 15%) instead of being taxed at your regular income level (which will be higher).

No Loss Deduction

One of the more minor drawbacks of a variable annuity is that there is no loss deduction for them. What does this mean?

In a regular investment, if you have a loss, you are allowed to deduct $3,000 of that loss from your taxes. You cannot do this with a variable annuity.

You also cannot do this with any other retirement account either. This is because all taxes gains and losses are deferred until you take the money out at retirement. (That is why it’s called a tax-deferred account.)

So if deducting a loss on your investments is important to you, you would be better off to put your money into an after-tax brokerage account rather than a variable annuity once you have maxed out all other retirement plans that are available to you.

No Stepped Up Basis

This is a big one that most people don’t think about. 

When you did and you have money left in a retirement account (401k, 403b, TSP, etc.) and you pass that money on to your heirs, there is what is called a stepped up basis.

This means that your heirs tax basis is whatever they inherited the money at.

For example, your mother puts money into her 401k throughout their working life. She puts $100,000 of her own money into it. With dividends and interest it grows to $400,000 by the time she retires.  When she retires, she starts to draw down on that money to live on. Then suddenly she dies and the money is passed to you. When she dies, there is $300,000 left in the account that you inherit.

Your tax basis is now stepped up to $300,000.

That means that you will owe $0 in taxes on the inherited money. So you will only owe taxes on any gains ABOVE $300,000. So if you let it grow to $350,000, you will owe taxes on $50,000 and not the original $300,000.

That is with a normal retirement account.

It is different with a variable annuity. Variable annuities do NOT have a stepped up basis.

In the same scenario but with a variable annuity, your tax basis will be $100,000. The basis is $100,000 because that is the amount of money that your mother put into the account herself. So the IRS looks at the first $100,000 as a return of the money that you put into the account. 

Everything above the first $100,000 is taxed at your ordinary income level. So you will owe taxes on $200,000. Ouch.

So if you are in a 24% tax bracket, your tax bill for inheriting a 401k will look something like this:

When to Use a Variable Annuity

As I have stated before, these products can be a useful tool if used in the proper circumstance.

But they should ONLY be used:

1. Once you have already maxed out every other retirement vehicle available to you
2. If you want even more tax deferred growth than you want to have money put into an after tax brokerage account.

The fees, surrender charges, and commissions are just too high to justify using a variable annuity at any time before you have met these two benchmarks.

Variable Annuities INSIDE of Retirement Accounts

This one is frustrating. I have seen it many times before. Someone who comes to me and they have a variable annuity that is inside of a retirement account (like an IRA or 401k). 

Retirement accounts have tax deferred growth. So do variable annuities. You don’t need to have tax deferred growth TWICE!

When you put money into a retirement account, some of the fees are to put your money into a tax deferred account.

Likewise, when you pay some of the fees to a variable annuity, you are also paying for a tax deferred account.

If you have a variable annuity inside of a retirement account, you have paid the same fees TWICE! Don’t do that. There is zero benefit for you.

(3) Differences Between Fixed Annuities and Variable Annuities

I know that I have thrown a lot of information at you about the differences between fixed annuities and variable annuities. But here is a chart that boils down everything that I have written up to this point.

Final Thoughts

There are several differences between fixed annuities and variable annuities. It is important to have a decent understanding of how they work before you purchase one. (The same should be said about ANY financial product that you purchase.)

Remember, an annuity (of any kind) is usually not going to be a good financial move for the bulk of people. Yes, fixed annuities and variable annuities have their place. But they are often touted as being a silver bullet for your money. They are not.

Be careful about these products.

I am here to help you in any way that I can!

You can do this!

Until next time!