How Does an Indexed Annuity Differ From a Fixed Annuity?

an asian chinese active senior woman having discussion with her chinese agent about her retirement investment plan

Are you concerned about running out of money in retirement? While it’s great news that people are living longer than ever–it makes planning for retirement much more difficult.

One approach to solving this longevity issue is purchasing an annuity that offers guaranteed income for a set period of time. There are several types of annuities to choose from–with fixed annuities and index annuities being two of the most popular options. While both provide steady income–each offers a different approach to providing income and growth.

Here’s an overview of how fixed annuities and index annuities work, the pros and cons of each, and when to choose one over the other.

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What Is an Annuity?

Annuities are a type of insurance contract that allows you to deposit funds–either in a single lump-sum payment or monthly premiums–in exchange for a guaranteed payout over a set period of time. Some annuities even pay out for life–meaning you will receive payments from your annuity until you die.

Annuities come in all shapes and sizes–with the most popular options offering a fixed-payment schedule and guaranteed rate of return. But there are also variable annuities that offer exposure to mutual funds and other investments for more potential growth.

Annuities can be held as stand-alone policies–or within a retirement account. All annuities defer taxes until you start receiving payouts, making them a tax-efficient way to invest for retirement.

But annuities may also come with high fees and commissions which can offset your gains and make them a poor investment vehicle for some. It’s important to understand how an annuity works and how fees are assessed before choosing one for retirement.

What Is a Fixed Annuity?

Fixed annuities offer a guaranteed minimum interest rate and fixed number of payments over a set period of time. Fixed annuities are similar to other types of fixed-income investments, such as certificates of deposit or U.S. Treasuries. You choose an interest rate and payout term–and receive payments based on your terms chosen. Fixed annuities are regulated by state commissioners.

There are two types of fixed annuities–immediate annuities and deferred annuities:

• Immediate fixed annuity. An immediate annuity starts paying you right away–and is usually funded with a lump-sum payment upfront–single premium. These annuities let you choose your payment term (a set amount of years or “lifetime”) and provide a guaranteed minimum interest rate for the life of the annuity.
• Deferred fixed annuity. A deferred fixed annuity allows you to pay lump-sum or monthly premiums into the annuity and has a set interest rate for a fixed amount of time–usually one to seven years. After the guaranteed interest period, the annuity will pay out a set minimum interest rate until the contract matures–usually at death or around 100 years old. You typically don’t draw from a deferred annuity until a later date.

Benefits of Fixed Annuities

Fixed annuities offer steady payouts and a guaranteed minimum return on your money. This is ideal for those close to retirement, or those who are currently retired and want a fixed guaranteed income they can count on.

Fixed annuities also use actuarial tables to project your life span. If you outlive your projected lifetime–a lifetime fixed annuity will continue paying out–making it a good way to guarantee there is income coming in if you live longer than expected.

If you choose a deferred fixed annuity, you are also protected from income taxes while your annuity grows in value. This can help you defer taxes until much later when you start receiving payments from the annuity.

What Is an Index Annuity?

Index annuities–also known as indexed annuities–are a hybrid investment and insurance product that offers investment returns based on a market index, such as the S&P 500. Index annuities allow investors to participate in some of the upside of a particular market–while limiting the downside risk.

Most index annuities offer a minimum guaranteed return–even if the market index it tracks is doing terrible. This minimum may just protect your principal investment–meaning a zero percent return–but you won’t lose any money. But index annuities typically cap the upside as well. For example; If there’s a 10% annual cap and the S&P 500 returns 25% during the year–you’ll only earn a 10% return.

Index annuities also have a “participation rate”–which is the amount of market return you have access to. For example; if your index annuity has a 75% participation rate and the index it tracks returns 10%–you would get a 7.5% return.

Benefits of Index Annuities

Index annuities allow you to potentially earn a higher return than other annuities based on market performance. This can help compound your money faster than a comparable fixed annuity.

Plus, most index annuities don’t allow you to lose money–the downside protects your invested capital–making it a lower-risk product than investing directly in the market.

And like other annuities, you can defer taxes on index annuities until you begin receiving payouts.

Fixed vs. Index Annuity: How They Differ

While both fixed and index annuities offer tax-deferred growth, downside protection of your principal investment, and add-ons such as riders and death benefits–there are differences in how they approach investments.

Fixed annuities offer guaranteed income and a fixed interest rate–typically based on prevailing interest rates. But index annuities offer growth by tracking a market index and sharing some of that growth with you.

Fixed annuities always pay out some interest–even after the fixed rate period ends. And while index annuities protect you from losing money, you might end up not earning anything during years when the market is down.

Pros and Cons of Fixed Annuities

Fixed annuities are a good investment for some–but might not fit the bill for others. Like an investment, there are upsides and downsides to consider. Here are a few pros and cons of fixed annuities:

Pros

• Guaranteed income in retirement
• Guaranteed minimum interest rate
• Grows tax-free until payments start
• Potential death benefits for beneficiaries (if you die before payouts begin)

Cons

• Locked-in interest rate
• May not keep up with inflation
• Fixed rate only locked in for a few years in most cases

Pros and Cons of Index Annuities

Index annuities offer guaranteed income and potential growth of your principal investment based on market index returns. But there are a few downsides as well to consider before buying one. Here are the pros and cons and index annuities:

Pros

• Returns track a market index,such as S&P 500
• May earn more than a fixed annuity
• Growth is tax-deferred until retirement
• Downside guarantee protects your principal investment

Cons

• Provides lower returns than directly investing in a market index fund
• Upside is usually capped
• May earn 0% returns during market downturns

Choosing a Fixed or Index Annuity

Both fixed and index annuities offer income for retirement with some tax advantages and investment protection. But choosing one over the other depends on your investment goals, risk tolerance, and other factors.

Fixed annuities are ideal for retirees than want a simple fixed-rate return on their money with a guaranteed payout for their lifetime. Whether you choose an immediate or deferred fixed annuity–you can count on the money being there month after month.

Index annuities are better for investors that want to take advantage of the growth in a market index without the downside of potentially losing money. And while the growth is capped, index annuities have the potential of earning more than a fixed annuity–but may also return nothing when the market index is down.

Overall, annuities may fill a specific need in your financial plan, and choosing one that fits your larger retirement planning needs can help offset some investment risk and protect your income in retirement. But they can be complicated products that can come with extra fees and options that could offset any of the positives–so it’s a good idea to work with a licensed financial planner to help you choose one that works before for your retirement goals.

FAQ

• Is it a good idea to have a fixed-rate annuity?
  • Fixed rate annuities can be a good idea for retirees looking to lock in guaranteed income for a set period of time and a fixed interest rate. Fixed annuities may also pay out for your lifetime–meaning you can receive a monthly check until you die. But fixed-rate annuities typically drop rates down to a much lower minimum rate after the fixed-rate period ends–and this amount may underperform other investments and fixed-income investment choices.
• What is the safest annuity to buy?
  • Fixed annuities are considered one of the safer types of annuities to buy because they offer a fixed-rate guarantee for a number of years, plus a guaranteed minimum rate of return after that. Other annuities may have variable returns–and might even lose money–but fixed annuities never lose your principal investment.
• How are fixed and index annuities taxed?
  • Both fixed and index annuities offer tax deferral until you start receiving payments or make a withdrawal. Taxation depends on whether your annuities are qualified–held in a retirement account, or non-qualified–stand-alone policies. If you hold your annuity inside a 401(k) account–qualified, you will pay ordinary income taxes when you start receiving payments from the policy. If you have a non-qualified annuity, you will only pay taxes on the earnings from your policy when you start receiving payments.
• What happens to my annuity if I die?
  • Most annuities have a death benefit that allows your annuity to transfer to your beneficiaries if you haven’t started receiving payouts from the policy. If you have already started receiving payouts from the annuity, then what happens when you die depends on the policy terms. Some annuities have a fixed death benefit that pays out to beneficiaries, while others don’t offer any death benefits.

This article originally appeared on GOBankingRates.com: How Does an Indexed Annuity Differ From a Fixed Annuity?