The key difference between a traditional annuity and a variable annuity lies in how the investment and payout components are structured. Here’s an overview of each:
- Traditional Annuity:
A traditional annuity, also known as a fixed annuity or a fixed-rate annuity, offers a guaranteed rate of return on the invested principal. The insurance company issuing the annuity provides this guarantee. The main features of a traditional annuity include:
- Fixed interest rate: The insurance company guarantees a specific interest rate for a predetermined period or the life of the annuity contract. The rate is typically higher than what you would receive from a savings account or fixed-income investments.
- Stable income stream: During the payout phase, the annuity holder receives regular payments, usually monthly, that are based on the initial principal, the guaranteed interest rate, and the annuity’s payout option. The payments remain fixed and do not fluctuate with market conditions.
- Lower risk and volatility: Traditional annuities offer a lower level of risk and volatility compared to variable annuities because the interest rate is fixed. This makes them attractive for individuals seeking stable income and capital preservation.
- Variable Annuity:
A variable annuity provides the potential for investment growth by allowing the annuity holder to allocate their contributions among a selection of investment options, typically mutual funds offered within the annuity. The key features of a variable annuity include:
- Investment options: Variable annuities offer a range of investment options, often referred to as sub-accounts, which are similar to mutual funds. These sub-accounts invest in various asset classes, such as stocks, bonds, or money market instruments. The annuity holder can choose how to allocate their contributions among these options based on their risk tolerance and investment objectives.
- Market-driven returns: The performance of a variable annuity is tied to the performance of the underlying investment options. The value of the annuity can fluctuate based on the performance of the chosen investments. This means that the investment returns and the payout during the annuitization phase can vary based on market conditions.
- Greater growth potential: Variable annuities offer the potential for higher investment returns compared to traditional annuities. However, the returns are subject to market volatility, and there is no guarantee of investment performance.
It’s important to note that variable annuities often come with additional features, such as death benefits or optional riders, which can provide added protection or benefits at an additional cost. Variable annuities typically have higher fees and expenses compared to traditional annuities due to the investment management and insurance features.
When considering an annuity, it’s crucial to carefully evaluate your financial goals, risk tolerance, and the terms and features of the specific annuity contract. Consulting with a financial advisor who specializes in annuities can help in understanding the implications and suitability of each type of annuity based on your individual circumstances.
