How Does an Indexed Annuity Differ from a Variable Annuity?

In past decades, more people have been buying annuities. A big part of this is due to the unique features that annuities offer, such as tax-advantaged growth and contractual guarantees such as lifetime income.

Of course, many kinds of annuities are available now. Knowing what annuity is right for your situation (if indeed a good fit) can be a challenge in some cases.

If you are looking for growth, then you might look at fixed index annuities or variable annuities, as they both offer more growth potential than traditional fixed-type annuities.

But to make a confident and well-informed decision here, it helps to know how these types of annuities are alike and how they differ.

At their core, both are contracts with a life insurance company for a certain period. Where their differences lie is how their money grows, their exposure to market risk, and the fees that they carry, among other things.

Some Key Distinctions Between Fixed Indexed and Variable Annuities

Here’s a rundown of the primary differences between a fixed index annuity and a variable annuity:

• One has direct market investments and the other doesn’t
• Variable annuities have more growth potential but more risk than indexed annuities
• Insurance companies treat each annuity type differently
• Both annuities have different fee schedules

Keep these distinctions in mind as you explore different options for your personal situation.

1. Direct Market Investments

Variable annuities let you invest directly in market-based funds. However, fixed index annuities don’t involve a direct investment of any sort.

When you put money into a variable annuity, you have a preselected assortment of mutual fund options that you can choose from. There will usually be several different types of funds, including:

• Stock funds
• Bond funds
• Real estate funds
• Commodities funds
• Money market funds

There are even “funds of funds” (a fund that invests in several other mutual funds).

These investment selections that are available to you inside a variable annuity are called “subaccounts.” They are directly in the market.

On the other hand, a fixed indexed annuity doesn’t have subaccounts. Nor is it directly involved in any financial market.

Unlike a variable annuity, which is a combination of an insurance and securities product, a fixed indexed annuity is strictly an insurance product. In an indexed annuity, your money earns interest based on an underlying financial benchmark to which the annuity contract is linked.

The carrier allocates your premium dollars into its general fund. Here, it puts most of the money (often more than 90 cents of every dollar) into underlying investments, which are mostly low-risk fixed-income assets, to support your annuity policy and others.

Most insurers put the remaining three to five cents of every dollar into call options on the specific underlying index benchmark.

For many indexed annuities, the underlying benchmark is the S&P 500 price index. However, you may have other index options depending on the fixed index annuity product.

How your money earns interest is based on the movements of this underlying index. When the index goes up, the interest you earn will be a percentage of that growth. When the index goes down, your principal and already-credited interest earnings are protected from any index losses.

2. Growth Potential and Market Risk

Variable annuities have more growth opportunity. However, they carry more market risk than fixed indexed annuities.

Since its subaccount options are directly invested in various markets, a variable annuity offers more potential for growth than any other type of annuity. However, the risks are also greater. All of your money inside a variable annuity is vulnerable to market losses.

You can lose some or even all of your money, including your principal, depending on how the subaccounts perform.

There isn’t as much growth opportunity with a fixed indexed annuity. However, this type of annuity guards your money with a “floor” of protection.

As described in the first point, when the benchmark index goes down, your money won’t earn any interest. The value of your contract simply stays the same.

The saying “zero is your hero” might come to mind as a simple overview of how this works.

On the other hand, insurers can limit the growth opportunity of a fixed indexed annuity with caps, participation rates, and spreads. This is a trade-off for an indexed annuity not having loss risk due to index declines.

3. Different Treatment by the Insurance Company

Insurance companies treat fixed index annuities differently from variable annuities.

An indexed annuity is often the “go-to” choice for annuity owners who want principal protection, but also more growth potential for their money than a regular fixed annuity can provide.

Its ability to earn interest based on an index, but with principal protection, is an attractive benefit for risk-averse retirement savers. But those with a higher risk tolerance are more likely to choose a variable annuity.

From the insurance company’s perspective, variable annuities are treated as individual “separate-account” products that may lose value. With a fixed indexed annuity, the insurer keeps all premiums in its general fund, making it a “general-account” product.

For upholding its insured obligations, the insurance company has strict capital requirements it must follow according to state insurance laws. For every dollar of premium paid into an indexed annuity policy, the insurance carrier must maintain dollar-for-dollar reserves in cash or cash-equivalent assets.

This is the minimum requirement for insurers. Most life insurance companies maintain higher capital reserves than the minimum dollar-for-dollar reserve, which is given as an insurer’s “solvency ratio.”

4. Different Fee Schedules

Variable annuities tend to come with more fees than fixed indexed annuities. Like other enterprises, insurance companies are in business to make money (and also to keep their guaranteed promises to you, the contract holder).

Because of the differences in how variable annuities are treated compared to fixed indexed annuities, as discussed above, insurers aim to profit from variable annuities in different ways than from indexed annuities.

Most variable annuities come with a menu of fees and charges. Some variable annuities can cost you as much as 2% and, even in some situations, up to 8% per year, depending on the insurance company and even how your subaccounts perform.

These can include:

• Mortality expenses
• Administrative expenses
• Fund management fees
• Annuity rider fees, and
• Annuity account fees (depending on the balance in your variable annuity)

The actual fees that are charged inside a variable annuity will vary somewhat from one insurance carrier to another.

In contrast, many fixed indexed annuities have low fees or even no fees at all. The insurer incorporates the costs of doing business into the contract design (such as some of the growth limits on your interest-earning potential).

If you have a lifetime income rider or another add-on benefit within your indexed annuity, you may pay an annual rider fee for that benefit. Some riders cost the annuity owner a fee of 0.95% per year.

Check your annuity contract and speak with your financial professional about what, if any, fees may be in your annuity contract.

One Key Similarity

Keep in mind, most annuities come with surrender charges and some free withdrawal limits that last for the duration of the surrender charge schedule. Fixed index annuities and variable annuities are no exception to this.

The surrender period of an annuity can vary. In many contracts, the surrender period goes from three years and up to fourteen years. The majority of annuity products today have surrender periods of up to ten years.

Be sure to check any annuity contracts that you are considering for the length of commitment. Your financial professional can help you with this.

What May Be Right for You?

Be sure to weigh the pros and cons of indexed and variable annuities. It’s good to thoroughly understand your options before committing to any annuity purchase. In fact, this is a good rule of thumb for all decisions to commit to any financial strategy or instrument.

Consult your financial advisor today for more information on both of these types of annuities and which type may be right for you.

Are you looking for a financial professional to help you with this and other important questions? For your convenience, many independent financial professionals are available at SafeMoney.com. They can assist you with these important what-ifs surrounding your financial future.

Use our “Find a Financial Professional” section to connect with someone directly. You can request an initial appointment to discuss your needs, concerns, and explore a working relationship. Should you need a personal referral, call us at 877.476.9723.