One of the most important parts of planning for retirement is making sure that the money you have saved continues to work for you after you have stopped working. Annuities are sold by insurance companies, typically as a retirement income option. You pay a lump sum of money to the insurance company in exchange for a guaranteed stream of income over time. Two of the most common types of annuities are fixed and fixed-index annuities, also known as equity-index. The primary difference between the two annuity products lies in the potential rate of return for each.
Rate of Return
The insurance company has three responsibilities with regard to a csutomer's annuity. It agrees to grow the principal investment at a particular rate of interest through investments, pay out a regular stream of income, and pay that amount for a designated payout period. A fixed annuity guarantees the holder a specific rate of interest on the money placed in the annuity. This means that no matter how the insurance company invests the money, it guarantees that your account will grow at a fixed interest rate. An indexed annuity, however, does not guarantee a fixed interest rate. Instead, the annuity's interest rate is pegged to a stock market index, such as the S&P 500. The fixed-index annuity guarantees a minimum interest rate and an upper threshold that will rise if the interest that the associated index pays rises.
A fixed annuity makes periodic payments that remain the same throughout the term of the annuity contract. Because a fixed-index annuity is pegged to an outside investment measure that can go up or down with the market, its periodic payment can change. A fixed-index annuity typically designates a minimum payment, but the payment can fluctuate once it exceeds that amount.
A fixed-index annuity has the potential to pay a higher rate of return if the market performs well. Conversely, a fixed annuity returns the same amount, whether the market is doing well or poorly. If you expect a market boom, the fixed-index annuity gives you a way to capitalize on it, while the fixed annuity is inflexible.
The fixed annuity is considered the safer investment vehicle because you know the specific rate of return and periodic payment. While a fixed-index annuity offers the potential for higher returns, there is also the possibility that the market will drop and the annuity will earn less than expected. The minimum guaranteed rate ensures that you will not lose money on an indexed annuity. But a depressed rate of return will affect the ability of the annuity to provide a steady and sufficient income stream.