Fixed Index Annuities vs Variable Annuities: Understanding the Difference

Introduction

Annuities can play a big role in retirement planning, especially when you're looking for steady income down the road. Whether you're five years from retiring or it's right around the corner, understanding how an annuity can fit into your overall strategy may make retirement income planning decisions a little easier. But– with the vast annuity universe out there, the question becomes: which type of annuity makes sense for you?

Two of the most commonly discussed types of annuities are fixed index and variable annuities. Both can offer long-term benefits, but each type of contract comes with its own approach to growth, risk, and income. Knowing the differences can help you feel more confident about the path you choose for the decades ahead. Let’s look at how annuities work and why the right fit depends on your personal situation.

Understanding Fixed Index Annuities

A fixed index annuity is fairly straightforward. You fund the contract, typically as a lump sum payment, and the insurance company contractually guarantees your principal.These policies are not directly invested in the market. Instead, the funds can be “linked” to a number of market indexes for growth potential.

Your potential for earning interest can be limited by caps, spreads, and/or participation rates. Over the years, fixed index annuity contracts have gotten much more complex with the manner in which they allow contract owners to earn credits. In many cases, the more complex the strategy, the worse it may be. Simplicity tends to trump complexity with these policies.

However, the principal protection feature is only one of the key benefits offered by fixed index annuities. A second key feature is that these contracts may often come with the potential for a lifetime income rider. These riders may be included or added, depending on the contract.

The key benefit of the income rider is that it allows the contract holder to create a contractually guaranteed income stream for life (or joint-life), without having to annuitize the contract. Essentially, it creates a pension-like income stream that will be paid out and guaranteed by the insurance company— even if the account value falls to $0.00. Payments will continue.

This type of contract structure appeals to people who value simplicity and predictability. Here’s why:

- You understand the your principal in the contract is not at risk in the market

- The lifetime income rider creates a predictable income stream

- Market swings don’t affect your income.

- It’s simple to understand and less intimidating for many people preparing for retirement

But there are limitations. The growth potential is generally lower than what you might earn in a market-tied investment. This means that you should not consider this type of annuity as a growth account. A fairer comparison might be as a bond-alternative or a stable, preservation account.

Here’s an example:

Jim and Lisa from Fort Mill are close to retiring. They’ve saved steadily and want to make sure their income stays steady through the years ahead. With bills still to pay and grandkids they want to help support, they like the idea of a fixed index annuity.. However, during their assessment, they come across a concern: What if interest rates rise later, or they could’ve earned more in other accounts?

That question makes them pause and reflect on what’s most important for their future—dependable income or the potential to grow their savings even more by staying in the market?

When Jim and Lisa examined their portfolio, they realized that roughly 45% of their holdings were already in stable positions like money markets and short-term bonds. Using an annuity to replace some of the bonds would allow them to keep their equity exposure unchanged, and it would also allow them to create a lifetime income benefit that would cover both of their lives.

They agreed that their remaining investments would be used as growth accounts to help them maintain their purchasing power, while the annuity allowed for increased spending today.

Fixed index annuities can be incredibly helpful for people who want to create a predictable income stream to supplement their other retirement income sources, but these contracts should always be considered within the context of the overall financial plan.

Understanding Variable Annuities

A variable annuity is different from a fixed or fixed index contract. It provides the contract holder an opportunity to grow the funds by investing directly into the market. Your lump sum or ongoing payments are invested into funds known as sub-accounts, which are similar to mutual funds. The value of your annuity changes based on the performance of these investments. These funds are not insulated from downside market risk.

Here are a few reasons someone might lean toward a variable annuity:

- There’s can be opportunity for higher potential returns than a fixed index annuity

- You typically to choose from a broader set of investment options

- Income can still be structured for life, just like with fixed index annuities

There are several downsides to consider. The first one is the higher level of risk. The value of your annuity may go down during a market decline. The internal fees and expenses can make recovering from a steep downturn a challenge for investors with a variable annuity.

Fees and costs can also be significantly higher than those of fixed index annuities or even traditional advisory accounts. High fees can cut into the net return for the contract. In some instances, the income generated can also fluctuate, which can make budgeting a challenge.

Now consider Robert and Dana from Rock Hill. They’ve worked hard, saved diligently, and now their retirement vision includes travel, helping fund college for their grandkids, and continuing to grow their nest egg. They have been told to consider a variable annuity because they’re open to taking some investment risk if it means their assets can grow along with their dreams.

Still, they must take time to carefully read the fine print and understand the cost of the added flexibility. Variable annuities can potentially work well for those who have a longer time horizon or who don’t mind the added market risk. But, they’re not for everyone. Taking on this kind of risk means being okay with potential underperformance due to down markets.

Factors to Consider When Choosing

The decision between fixed index and variable annuities depends on your personal goals, risk tolerance, need for income, and current financial plan.

Start with a few key questions:

- Do you want to maximize your retirement income, or are you looking to grow your account more? If you are looking to maximize your retirement income, a fixed index annuity may be a good fit. If you are looking for growth, you should evaluate a variable annuity against a traditional growth account.

- How much fluctuation are you willing to tolerate in your investments? Fixed index annuities, in our view, are not growth accounts. Yes, they may be able to earn interest in positive market years. However, we believe a more fair comparison to their return potential is comparing them to bonds. The key feature that fixed index annuities have is that they are principally protected, so they do not lose value based on a market decline. Variable annuities, on the other hand, do have higher growth potential. The trade-off is that variable annuities also put your account value at risk.

- Do you already have income sources like pensions, Social Security, or rental properties? If you already have strong income sources in retirement, then an annuity could potentially increase your spending today; or it may allow you to add another income stream at some point in the future. Both variable and fixed index annuities have this ability.

- Are you planning to access this money in the near term or is this for much later? Timing is one of the key factors to consider with annuities. Since income payouts are often tied to age and/or life expectancy, the payments you can receive can get larger if you defer taking them for a period of time. It’s important to compare the income payments in an apples-to-apples comparison. Also, another key feature to understand is whether or not the payments can ever reduce in the future!

- How do your other accounts such as IRAs or 401(k)s factor in? A better way to frame this question is simply to ask “How does the annuity fit into the overall financial plan?”

Let’s think about Carl and Denise from Tega Cay. They’ve just celebrated 35 years together but have very different views when it comes to money. Carl feels comfortable with the ups and downs of the market. Denise, however, wants simple, predictable income and isn’t interested in watching investment charts.

After sitting down with a financial advisor in Fort Mill, they found a solution. Carl allocated part of their funds into a long-term growth portfolio, while Denise opted to use some of her funds into a fixed index annuity with a lifetime income option. This strategy satisfied both of their preferences and helped them align on a retirement plan they were both excited about.

Denise would enjoy more consistent, higher spending in retirement; and Carl can maintain a long-term focus with the growth account. That’s often the case with couples. One person might be more aggressive, while the other leans cautious. Talking through those differences and coming up with a shared plan makes the transition into retirement much smoother.

More Clarity for Years to Come

Learning about the differences between fixed index and variable annuities means giving yourself the information you need to make good decisions. It’s a chance to retire with more clarity. Whether you’re the type that needs a steady check every month or someone who’s okay with letting investments fluctuate, your retirement experience depends on understanding your financial choices.

Every annuity option has trade-offs. You might give up some flexibility for predictable income, or you might let go of guarantees to chase better growth. The clearer you are about what you care most about—whether that's income security, flexibility, or long-term upside—the easier the choice becomes.

Working with a financial expert who listens to your concerns and understands how to tailor solutions can lessen the chance of missteps. These decisions affect not just the next few years but the rest of your life. With the right plan, you can focus on enjoying your retirement without revisiting big financial questions any more than you have to. Give yourself the space to live well, knowing your money is doing exactly what you intended.

For those ready to plan for their retirement while balancing growth and stability, exploring your options with our team can help you move forward with more peace of mind. At Vertex Capital Advisors, we’re here to guide you through decisions that support your goals for the years ahead.

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An Annuity is a long-term financial product designed largely for asset accumulation and retirement needs. All guarantees are backed by the claims-paying ability of the issuing insurance company. Annuities generally contain fees and charges which include, but are not limited to, surrender charges, administrative fees and for optional contract riders and benefits. Withdrawals and death benefits may be subject to income tax. If withdrawals and other distributions are received prior to age 59 ½, a 10% penalty may apply. Annuities typically carry surrender charges for several years that may be assessed against withdrawals. Certain annuity product features, such as stepped-up death benefit, a bonus credit, and a guaranteed minimum income benefit, will generally incur additional fees. If you are investing in an annuity through a tax-advantaged plan such as an IRA, you will get no added tax advantage. Any comments regarding safe or secure investments or guarantees of income refer only to fixed insurance products and do not refer in any way to securities or investment advisory products.