Advice on Fixed Variable Annuities

What are fixed variable annuities?  Well to start out with fixed annuities are those contracts that provide a fixed rate of return with no market volatility of the principal. The annuity is invested in securities that will not fluctuate in value with the value of the underlying security.  The rates may be reset periodically based upon your contract.  Your returns will be the lowest available in the market because you are excepting only the lowest risk with your investing.

A variable annuity is one in which the funds are invested in the stock market by way of mutual funds.  The value of the annuity will move up and down as the stocks in the mutual funds change values.  There is no set guarantee with a variable annuity.  Your value fluctuates with the underlying value of the investments.

A fixed variable annuity is a variable annuity that is invested in subaccounts that consist of fixed rate securities.  These funds may include corporate bonds, government bonds or even CDs.  The value of fixed rate securities in bond funds can fluctuate widely depending on the underlying interest rate fluctuations in the economy.  Normally fixed rate securities will fluctuate less than the stock market but not always.  Interest rate changes are also a bit more predictable that changes in the stock market direction.

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Example of Long Term Bond’s Changing Value with Changing Interest Rates

Here is an example of how fixed income securities can fluctuate in value. A 30 year bond may have an interest of 6%.  That rate is fixed for 30 years.  That means that the bond will pay 6% each an every year and the principal amount of the bond, usually $1000 will be paid back to the bondholder by the borrower at the end of 30 years.  Suppose that in 10 years the market interest rates on a bond having 20 years until maturity is 10%.  The resale value of your bond that is paying only 6% would be lower.  To make it marketable the price would have to drop to $600.00 to make it equivalent to a $1000 bond paying $100.00 per year.

This example is given to explain that difference between a fixed rate annuity where the principal value of the annuity stays the same versus a fixed subaccount inside a variable annuity.  The fixed subaccount may be a good place to be when the stock market is moving down, but it is not without fluctuation.  It may fluctuate less than the stock market though.  This is why many people choice this option.

Why Not Just Take a Fixed Rate Annuity?

Many people are afraid to go into the stock market mutual funds but they also do not want to get the low rates that a fixed annuity will offer.  They are willing to take some risk but just not the maximum risk.  A fixed variable annuity will pay a rate that is much higher than the CD type fixed annuity but you must accept fluctuations in principal value.

If you are in the fixed subaccount of a variable annuity most contracts will also allow you to switch to other subaccounts several times during the year.  You may feel that the stock market is very low and that it should go back up at some point.  You can get the fixed income fund returns and then when you feel the time is right, switch to stock market mutual funds.

If you are in a fixed annuity you do not have this option. You are locked into the rate for a set number of years. If you come out of the fixed annuity to take advantage of the low level of the stock market you will have a surrender charge that can completely wipe out all the interest you earned for the time you were in the fixed annuity. You can actually lose money on the fixed annuity if you come out of it in the early years.

So the reason for going into a fixed variable annuity is that you have flexibility and the potential for higher overall returns.  Obviously, you need to have time on your side as well to allow for the fluctuations in the underlying securities to work to your advantage.

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Who Should Consider Fixed Variable Annuities?

Fixed variable annuities should be considered by people who have a medium level of risk tolerance.  If you are very gun shy of any volatility in your account value, this is probably not the place for you.  However, if you want a better rate of return and are willing and able to ride out some of the storms that can hit the fixed income markets this is a good way to get those returns. 

Concluding Remarks

Variable annuities typically have higher expenses than a fixed annuity will have.  However, with a variable annuity even a fixed variable annuity you will have flexibility. There is no flexibility with a fixed annuity. The extra expenses may be made up with higher returns.  The extra costs should be considered as opportunity costs.  You have the opportunity to make higher returns.  Obviously the more time you have the better.

The buyer of this type of annuity would be someone who is able to accept some fluctuations in the principal value of the annuity over time in an effort to get a higher rate of return.  They should be able to take a medium level of risk.  If a person is completely risk averse, this is not the right choice for them.

Remember that you have no choices if you are in a traditional fixed annuity.  You are released from most of the risk of investing but you pay a price for that benefit.  The price is that your returns are the lowest returns in the marketplace.  You will be locked in for a number of years with a regular fixed investment which can cause you to actually lose money if you change your mind early on.

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