Annuities are among the most common financial products currently available in the market. In 2022 alone, annuity sales exceeded $310 billion, setting an annual sales record for these products. But despite their popularity, these products are among the most poorly understood financial vehicles available to investors.

Their complex structure and the sometimes-questionable tactics used to market fixed and variable annuities can cloud investors’ understanding of these unique products. We hope to clear up some of that confusion by examining variable vs. fixed annuities in detail — outlining their structure, costs, liquidity, tax implications, and suitability. However, before diving deeper into the nuances of annuities, let’s first break down the difference between fixed vs. variable annuities.

While there are many differences between fixed and variable annuities (as well as some similarities) and there are a number of different variations of each type, the primary characteristic that separates fixed and variable annuities is the way in which the contract value changes over time (and thus, the value of the cash flows that ultimately get paid to the contract owner). Aptly named, fixed annuities grow at a guaranteed, fixed rate from the time they are purchased to the commencement of annuity payments. Owners of fixed annuities know at the time of their purchase what the value of the future cash flows will be that are generated by the annuity.

Obviously, the number of cash flows cannot be known beforehand (as this depends upon the contract owner’s lifespan), but the guaranteed, fixed interest rate at least gives the owner some level of certainty of future income from the annuity. Variable annuities, on the other hand, grow at a variable rate, typically determined by the performance of various stock and bond investments. While this difference seems simple and straightforward, it can significantly impact the value that a contract owner ultimately derives from his or her annuity, and it creates substantial uncertainty for the contract owner. It also typically has a material impact on the level of fees that a contract owner pays to the issuing insurance company. We will delve into these effects as we examine both fixed and variable annuities in greater detail and shed some light on their inner workings.

What Is a Fixed Annuity?

A fixed annuity is a contract between a consumer and an insurance company in which the insurance company agrees to pay the contract owner a set amount of income over a specified period of time in exchange for either a one-time lump sum payment or series of payments over time. A fixed annuity contract transfers market risk, interest rate risk, and/or longevity risk (the risk of outliving one’s assets) from the contract owner to the insurance company.

There are two basic types of fixed annuities: immediate annuities and deferred annuities. The primary difference between the two is the timing of the first payments made by the insurance company to the contract holder.

As the name implies, the owner of an immediate annuity contract begins to receive annuity payments immediately upon purchasing the annuity contract. Such a contract, also often referred to as an “income annuity,” is purchased with a single lump sum payment made in exchange for a guaranteed series of payments to the contract owner for the remainder of his or her life.

What Is a Deferred Annuity?

A deferred annuity is a contract that obligates the issuing insurance company to pay the contract owner a stream of cash flows starting at a predetermined date in the future. Between the time of purchase and the time when payments commence, a deferred fixed annuity increases in value based on the cumulative payments made into the annuity and a guaranteed, fixed rate of return. A deferred annuity can be purchased with a lump sum payment or with a series of payments over time.

Fixed annuities are often used by older investors who have limited assets but who want to offset the risk of outliving their assets. Fixed annuities can serve as an effective tool for this purpose, though not without certain drawbacks. For example, in the case of immediate annuities, once a contract has been purchased, the contract owner relinquishes any and all control over the annuity assets. The only liquidity provided by most immediate annuities is the guaranteed series of cash flows that issuing insurance companies are contractually obligated to pay to contract owners. Certain annuity contracts may allow owners to borrow against future cash flows, but these provisions are typically very limited and may have adverse tax consequences.

Deferred annuities also come with their own liquidity issues. Deferred annuities typically have a surrender period (10 years is most common) that begins immediately after the contract is purchased. During this time, if the contract is canceled or any withdrawals are made, the proceeds received by the contract owner will be materially reduced by a surrender charge that is determined by how long the contract has been in force. For example, a contract with a typical 10-year surrender period would charge a 10% surrender charge if the contract was surrendered in the first year, a 9% surrender charge in the second year, and so on until the surrender charge reaches 0% in the contract’s 11th year. Some deferred annuity contracts contain language that allows for small withdrawals to be made at various intervals during the surrender period without penalty, though these allowances typically come at a cost in the form of lower guaranteed interest rates.

Who Bears the Risk in a Fixed Annuity?

Beyond a lack of liquidity, fixed annuities have other drawbacks as well. While fixed annuities grow at a guaranteed rate, this rate is typically well below what an investor could earn by investing in high-quality bonds. This difference is what compensates the issuing insurance company for assuming market and longevity risk from the contract owner. Owners of fixed annuities (or any type of annuity product, for that matter) also assume counterparty risk. The guarantees embedded in fixed annuity contracts are subject to the claims-paying ability of the issuing insurance company. Thus, a fixed annuity is only as good as the company that backs it. If an insurance company that has issued fixed annuity contracts gets into financial trouble, it is possible that the company could default on its payment obligations to contract holders. Many states do have certain safeguards in place to mitigate this risk, but it should be a consideration nonetheless for anyone considering the purchase of a fixed annuity.

What Are Variable Annuities?

At the most basic level, a variable annuity is effectively a mutual fund or collection of mutual funds with an insurance contract wrapper. Just as with a fixed annuity, the owner of a variable annuity pays an insurance company a lump sum or series of payments in exchange for the promise of a series of future payments in return. But as mentioned above, while a fixed annuity grows at a guaranteed, constant rate, a variable annuity grows at a variable rate that depends upon the performance of the underlying investments, called sub-accounts.

During the accumulation phase of an annuity contract, a variable annuity owner contributes money to his or her annuity, and that money is used to purchase “accumulation units” in the insurance company’s separate account. The separate account purchases shares in various sub-accounts, which are managed portfolios of stock and bond mutual funds. These sub-accounts allow annuity owners to participate (to a certain extent) in the performance of various markets. Many annuities also have a fixed interest rate option in which the insurance company guarantees a certain minimum annual interest rate. Typically, variable annuity owners can reallocate funds among the available investment options, though such asset re-allocations may be subject to a transfer fee. During the accumulation phase, assets invested in variable annuity sub-accounts grow on a tax-deferred basis and are taxed only when the contract owner withdraws those earnings from the account.

After the accumulation phase comes the income phase. Over time, variable annuity assets should theoretically increase in value until the contract owner decides he or she would like to begin withdrawing money from the account. The income phase begins when the contract owner decides to “annuitize” the account, meaning that he or she will begin to receive regular payments from the insurance company. The size of payments depends on the contract value, the future performance of the underlying sub-accounts, and the duration over which the contract owner wishes to receive payments. Therefore, unlike a fixed annuity (where future payments are pre-determined), variable annuity payments are subject to variability.

The most commonly cited reason for buying a variable annuity is the guarantee against loss of principal. As described above, most variable annuity contracts have some form of guarantee that limits or eliminates the losses that a contract owner would otherwise experience in down markets. A fear of an extended period of poor investment returns is what drives most variable annuity buyers to allocate capital to this type of product. However, these guarantees come at a high cost, as variable annuities typically charge all-in fees of 3-4% of the contract value each year. This can be double or triple what comparable managed investment accounts or standalone mutual funds charge, thus significantly hampering the long-term growth capability of these contracts.

Many variable annuity buyers also cite favorable tax treatment as a motivating factor in purchasing a contract, as annuity growth is tax-deferred during the accumulation phase and is only taxed when the contract owner begins to receive payments from the annuity. Individuals who are in a high tax bracket and who have exhausted all the other tax-advantaged savings options available to them (e.g., IRAs, 401(k)s, etc.) may find value in the tax deferral offered by variable annuities. However, just as with other tax-advantaged retirement vehicles, withdrawals made from an annuity prior to age 59½ may be subject to federal and state tax penalties.

While there are ostensibly some advantages of variable annuities, these benefits are largely (if not entirely) offset by some material drawbacks that make them, in our estimation, unsuitable for most investors.

Cost: The most significant issue that variable annuities typically present is high cost. Variable annuities have several layers of fees and expenses that can, in aggregate, create a drag of up to 3-4% of the contract’s value each year. Below are the most common fees associated with variable annuities.

  • Mortality and expense (“M&E”) risk charge

This expense compensates the insurer for the risk that it assumes under the terms of the contract. Effectively, this is the cost of the “insurance wrapper” that the contract owner purchases as part of the annuity contract. M&E expense charges are calculated as a percentage of the contract value

  • Administrative fees

Annuity issuers pass on recordkeeping and other administrative costs to the contract owner. This can be in the form of a flat annual fee or a percentage of the contract value. Administrative fees may be included as part of the M&E risk charge or may be assessed separately.

  • Fund management expenses

Variable annuities that are invested in mutual fund sub-accounts must also pay management fees charged by the underlying mutual fund managers. These fees can range from 0.1% for passive funds to 1.5% or more for actively managed funds.

  • Rider charges

Annuity contracts can be customized in a number of ways to serve the specific needs of the contract owner. Some common variable annuity riders include guaranteed minimum accumulation benefit (GMAB), guaranteed minimum withdrawal benefit (GMWB), and guaranteed minimum income benefit (GMIB). Riders such as these, as well as most others, typically come with material additional cost.

  • Surrender charges

Like with fixed annuities as described above, variable annuities often have lengthy surrender periods that can materially reduce the value of a contract, should an owner need to withdraw money from the annuity while the surrender period is in effect. These surrender periods generally exist to ensure that issuing companies are able to recoup the cost of commissions paid to annuity salespeople.

Tax Treatment: Somewhat ironically, while favorable tax treatment is often cited as a major reason for purchasing an annuity, variable annuities may actually have some meaningful disadvantages with regard to tax treatment in comparison to many taxable investment accounts.

  • Ordinary vs. capital gains tax

As mentioned previously, taxes on earnings enjoyed by a variable annuity are deferred until those gains are withdrawn, at which time they are taxed as ordinary income. While this could be advantageous for investors who are in a high tax bracket, investors in low or moderate tax brackets may actually end up paying more in taxes upon withdrawal of funds from an annuity than if they had simply paid capital gains taxes on the realized earnings generated by investments in a taxable investment account. While it is true that distributions from other tax-deferred accounts such as IRAs and 401(k)s are also taxed at ordinary income rates, in many cases there is a tax deduction for the initial contribution to these accounts. Variable annuity contributions provide no such tax deduction.

  • No cost-basis adjustment

Variable annuities tend to be highly inefficient vehicles for passing wealth to the next generation because they do not enjoy a cost-basis adjustment when the original contract owner dies. When the owner of a taxable investment account passes away, the cost bases of the investments held in the account are adjusted to reflect the market prices of those investments at the time of the owner’s death. In the case of securities that have appreciated in value, this zeroes out any unrealized gains on those investments, along with any associated tax burden that would otherwise fall on the deceased account owner’s heirs. Therefore, heirs can inherit a taxable investment portfolio with a “clean slate” from a tax perspective.

Such is not the case with variable annuities. Investments held within a variable annuity do not receive a cost-basis adjustment when the original owner of the annuity dies. This means that any accumulated unrealized gains will be passed on to the annuity owner’s heirs, along with the associated tax burden. Even worse, beneficiaries must pay ordinary income tax rates on distributed gains rather than capital gains rates.

Conflicts of Interest: One significant issue related to variable annuities is the potential for conflicts of interest that may exist on the part of annuity salespeople. Unlike a financial advisor, who has a fiduciary duty to make investment decisions that benefit the client, an insurance broker has no such fiduciary obligation. Annuity sales are highly lucrative for the insurance professionals who sell them because of high upfront sales commissions. This defining feature is especially true in the case of variable annuity sales, which may pay sales commissions of up to 10% (or more) of the annuity contract’s value. The strong financial incentive for insurance salespeople to push variable annuity products raises questions regarding the suitability of such products for many investors to whom they are sold. Investors who are considering purchasing a variable annuity should fully consider these potential conflicts of interest when determining whether or not such a product makes sense in the context of his or her financial goals.

Growth Caps: While variable annuities are designed to allow investors to participate in the growth of various securities markets, many variable annuities actually limit the degree to which contract holders can enjoy such growth when it occurs. Many variable annuity contracts contain language which places a cap on the percentage of gain that can be experienced by certain sub-accounts. These caps prevent the annuity owner from fully participating in a portion of gains that could otherwise be enjoyed in years in which markets generate substantial returns. From an outsider’s perspective, it would seem that investors are trading a cap on investment returns for the aforementioned guaranteed floor on investment returns.

Lack of Liquidity: Variable annuities are highly illiquid investment vehicles. As noted above, surrender charges can severely limit an annuity owner’s ability to move assets out of an annuity in the early years of the contract. Further, while most variable annuities allow contract owners to withdraw a specified amount during the accumulation phase, withdrawals beyond this amount typically result in a company-imposed charge. Any withdrawals of gains are subject to ordinary income taxes on the Federal level and associated state income taxes, and withdrawals made before the contract owner reaches age 59 ½ may be hit with an additional 10% tax penalty. Withdrawals made from a fixed interest rate investment option could also experience a “market value adjustment” or MVA. An MVA adjusts the value of the withdrawal to reflect any changes in interest rates from the time that the money was invested in the fixed-rate option to the time that it was withdrawn.

Complexity: Variable annuities can be extremely complex products, which can confuse buyers and obfuscate fees and expenses. Quite often, even the salespeople who sell them do not fully understand how they work, and so salespeople sometimes prey on a buyer’s emotions to sell variable annuities rather than the merits and suitability of the products themselves. We believe that investors should fully understand what they own and how much they are paying to own it.

Counterparty Risk: Variable annuity assets invested in variable sub-accounts are considered assets of the contract holder and not the issuing insurance company, meaning that these assets would not be at risk in the event of an insurance company failure. However, the same cannot be said for variable annuity assets held in fixed-rate investments. These assets legally belong to the insurance company and would therefore be at risk if the company were to fail. Similarly, any guarantees that the insurance company has agreed to provide, such as a guaranteed minimum income benefit, would be in question in the event of a business failure. There are some third-party protections in place for variable annuity owners, such as state guaranty associations, but these protections are limited. Therefore, potential purchasers of variable annuities should understand and consider the financial condition of the issuing insurance company before entering into an annuity contract.

Who Do We Think Should Own a Variable Annuity?

While the advantages and drawbacks of various types of annuities can be debated, the real issue surrounding annuities is that of suitability. Put simply, the question is: who should own a variable annuity? This question can be difficult to answer, given the myriad variations available in the variable annuity universe, but there are some basic guidelines that can help investors decide whether or not annuities should play a role in their financial plans.

Given the structure, costs, tax treatment, etc. of variable annuities, it would appear to us that the only investors who should consider owning variable annuities would be those who:

Are in a high-income tax bracket and expect to be in a lower tax bracket in retirement;

  • Have exhausted all other tax-deferral vehicles;
  • Have little need for liquidity;
  • Expect to have a substantial remaining lifespan;
  • Are comfortable relinquishing control of their capital to an insurance company;
  • Are willing to accept full or partial constraints on the transfer of assets to their heirs upon their demise;
  • Have a very low tolerance for investment loss.

This situation is highly limited; few people really fit this rather tight description. Individuals who do not meet these criteria would be better served, in our estimation, by putting their capital toward other types of investments that could potentially generate greater returns that are not dragged down by the high fees associated with variable annuities while also providing greater liquidity and potentially more optimal tax treatment.

Closing Thoughts

We believe we have taken an unbiased and nuanced approach to analyzing fixed and variable annuities. In our view, fixed annuities may be appropriate for certain investors who have limited assets and a high risk of outliving their assets, though such investors should fully understand the drawbacks and limitations associated with allocating a portion of their capital to these vehicles. Variable annuities, however, have few, if any, appropriate applications in our opinion, given the issues outlined above. As with any product, financial or otherwise, consumers should understand the pros and cons of what they’re buying in order to make informed decisions. After all, as the saying goes: “Buyer beware!”

This article is prepared by Pekin Hardy Strauss, Inc. (“Pekin Hardy,” dba Pekin Hardy Strauss Wealth Management) for informational purposes only and is not intended as an offer or solicitation for business. The information and data in this article does not constitute legal, tax, accounting, investment, or other professional advice. The views expressed are those of the author(s) as of the date of publication of this article and are subject to change at any time due to changes in market or economic conditions. Pekin Hardy cannot assure that the strategies discussed herein will outperform any other investment strategy in the future.