When you buy a deferred annuity, you make a premium payment to an insurance company and begin to receive income derived from the premium at a future date. You can also opt to make a lump-sum withdrawal rather than convert your premium into an income stream. Fixed and variable annuities are both types of deferred annuities and therefore have some similarities. However, the two annuity types are also different in many respects, including fee structure and in terms of how your premiums are invested.
The funds you use to buy a fixed annuity are invested into an account that pays a fixed rate of return. You can buy fixed annuities that have a fixed rate for the entire term of the annuity or annuities that have a rate guarantee for the first year and then reset based on the prevailing interest rates thereafter. Insurance companies refer to the period of time that your funds are invested as the "accumulation phase."
You can choose to invest your variable annuity premiums in a fixed account but you can also invest your premiums in mutual funds. Your returns are based upon the performance of those funds over the term of the annuity contract.
Annuities are not federally insured but state insurance guaranty funds provide you with at least $250,000 of insurance coverage in the event that the annuity issuer becomes insolvent. Fixed annuity contracts typically have a provision that allows you to withdraw your premium, penalty-free, prior to the end of the accumulation phase.
You cannot make principal withdrawals from a variable annuity during the accumulation phase and if you invest in mutual funds your principal may lose value during the contract term. However, you can pay a fee to buy an insurance rider that provides you with minimum performance guarantees and principal protection even if the account loses value.
You do not pay a fee to invest in a fixed annuity. The only fees you could incur while holding a fixed annuity are interest penalty fees, which you pay if you withdraw funds from the contract during the accumulation phase.
When you buy a variable annuity, annual contract fees are deducted from your account. These fees can amount to more than 4 percent of the contract's value. You also pay a penalty fee of up to 8 percent if you withdraw money from the annuity during the accumulation phase. The accumulation phase on both fixed and variable annuities typically lasts for between four and 10 years.
If you hold a variable annuity contract in a brokerage account and your broker goes bankrupt, the Securities Investor Protection Corporation covers up to $500,000 of your losses. The SIPC does not provide insurance protection for fixed annuities held in brokerage accounts.
Investors often buy fixed annuities as alternatives to certificates of deposit when rates on bank CDs are low. Variable annuities are typically bought by investors who want to grow their money as much as possible without taking the risk of losing all of their principal by investing directly into the stock market.