Fixed Indexed vs. Variable Annuities: The Differences That Matter

"Annuity" covers a lot of very different products. Two of the most commonly confused are fixed indexed annuities (FIAs) and variable annuities (VAs). They both grow tax-deferred, they both can offer lifetime income, and they're both sold by insurance companies. But they handle risk in completely different ways, and they're regulated differently too.

Here's a plain explanation of how each one works so you can understand what you own, or what you're being offered.

A note on transparency: I'm licensed to offer fixed and fixed indexed annuities, not variable annuities. Variable annuities are securities, and they're sold by professionals who hold securities licenses. This post explains both so you can compare them; it isn't a recommendation to buy or sell either one.

How a Fixed Indexed Annuity Works

With an FIA, your money isn't invested directly in the stock market. Instead, the insurance company credits interest based on how a market index (such as the S&P 500) performs over a set period, within limits:

• A floor, usually 0%, so a down year in the index doesn't reduce your account value through crediting.
• A cap, participation rate, or spread that limits how much of the index's gain you receive.

So you give up some upside in exchange for protection from market losses. The same crediting ideas apply to indexed life insurance, explained in how index crediting works. FIAs are insurance products regulated by state insurance departments.

How a Variable Annuity Works

With a VA, your money is invested in subaccounts, which are similar to mutual funds. Your account value rises and falls with those investments, so you can gain more in strong markets and lose money in weak ones. Because of that market exposure, variable annuities are regulated as securities as well as insurance. They come with a prospectus, and they're sold by professionals registered to sell securities.

The Key Differences

1. Risk to your account value

An FIA's crediting floor protects the account from index losses, though fees for optional riders and withdrawals can still reduce the value. A VA's account value can go down when the investments go down.

2. Growth potential

A VA has more upside potential because there's no cap on market gains. An FIA's upside is limited by its cap, participation rate, or spread, and the insurer can adjust those over time within the contract's guarantees.

3. Fees

Variable annuities typically have several layers of fees. According to state securities regulators, a mortality and expense charge is often around 1.25% per year, plus administrative fees, the expenses of the underlying funds, and the cost of any optional riders. FIAs usually don't have a base annual fee, though optional income or death benefit riders typically carry an annual charge. Both commonly have surrender charges for several years.

4. Regulation and paperwork

FIAs are regulated as insurance. VAs are regulated as both insurance and securities, which is why you'll receive a prospectus describing the investment options, fees, and risks.

What They Have in Common

• Tax deferral: Growth isn't taxed until you withdraw it. Gains come out as ordinary income, and withdrawals of gains before 59½ may face a 10% IRS penalty.
• Surrender periods: Both are long-term products with charges for leaving early.
• Income options: Both can be turned into lifetime income, either through annuitization or an optional income rider. For how guaranteed income fits a plan, see how annuities create guaranteed lifetime income.
• Guarantees backed by the insurer: Any guarantees depend on the claims-paying ability of the issuing insurance company.

Questions to Ask About Any Annuity

• What is my money actually invested in, or how is interest credited?
• Can my account value go down? Under what circumstances?
• What are all of the annual fees, in dollars, at my account size?
• How long is the surrender period, and what does it cost to leave each year?
• If there's an income rider, what does it cost and what exactly does it guarantee?

If you already own an annuity and aren't sure what kind it is, your contract and annual statement will tell you. My annuity review checklist is a good place to start.

Want Help Understanding What You Own?

I'm based in League City and help people across Clear Lake, Friendswood, Webster, and the Bay Area understand their fixed and fixed indexed annuity options in plain English. If you own a variable annuity, I can explain how it compares in general terms, and you should review any change to it with a securities-licensed professional and your CPA.

Frequently Asked Questions

Can you lose money in a fixed indexed annuity?

Index crediting in a fixed indexed annuity has a floor, usually 0%, so a market drop doesn't reduce the account through crediting. You can still lose money by surrendering early (surrender charges), and optional rider fees can reduce the account value in years with little or no interest credited.

Why do variable annuities have higher fees?

Variable annuities typically include a mortality and expense charge, administrative fees, the expenses of the underlying investment subaccounts, and charges for any optional riders. Together these can add up to more than a fixed indexed annuity's costs. The prospectus lists every fee.

Is a variable annuity a security?

Yes. Because the account is invested in the market through subaccounts, a variable annuity is regulated as a security as well as an insurance product. It's sold with a prospectus by professionals who are registered to sell securities.

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