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Taking Care of Mom and Dad: Fixed vs. Variable Annuities

There are two principal types of annuities: fixed and variable.

A fixed annuity is a fully guaranteed investment contract. Principal, interest and the amount of the benefit payments are guaranteed. In other words, what happens to the money in a fixed-income annuity is spelled out legally.

By guaranteeing both the principal and the interest, a fixed annuity is like a CD purchased from a bank. However, a CD is backed by the Federal Deposit Insurance Corporation (FDIC). A fixed annuity is not -- its security is directly related to the financial health of the company selling it.

There are two levels of guaranteed interest for a fixed annuity: current and minimum. The current guarantee reflects current interest rates and is guaranteed at the beginning of each calendar year. The policy also will have a minimum guaranteed interest rate -- such as 3 or 4 percent -- which will be paid even if the current rate falls below the policy's guaranteed rate. These minimum rates are set by state law.

In 2001 and 2002, with interest rates declining, fixed annuities became hot investment properties again. But those same low interest rates made it hard for some insurance companies to meet the minimum rate requirements. So, some companies increased fees and played other games to recoup money.

A variable annuity -- like variable universal life insurance -- is designed to provide a hedge against inflation through investments in a separate account of the insurance company, consisting primarily of common stock. If the portfolio of securities performs well, then the separate account performs well, so the variable annuity -- backed by the separate account -- also will do well. If the company's investments don't do well, neither does the annuity. In other words, there is investment risk involved; there is no guarantee of principal, interest or investment income associated with the separate account.

An insurance company or salesperson will provide a prospectus when your parents are considering a variable annuity.

Different annuities will offer people different investments, which offer different degrees of risk and reward. The investment options include stocks, bonds, combinations of both or accounts that provide for guarantees of interest and principal. By choosing among the available fund options, your parents can create an annuity that meets their objectives -- and their tolerance for risk.

If the funding options your parents choose for their annuity perform well, they'll more than exceed the rate of inflation -- or the rate for fixed annuities. If they don't, they may lose not only prior earnings, but even some of their principal. However, some policies will guarantee that the value cannot fall below a minimum level. A fixed account option will guarantee both principal and interest, much like a fixed annuity. This way, your parents have the option of dividing their money between the low-risk fixed option and high-risk funding options, such as stocks, all in one annuity.

With either type of annuity, expenses are deducted from earnings. Either a fixed or a variable annuity can guarantee expenses, which means any deductions made to annuity benefits are guaranteed not to exceed a specific dollar amount or percentage of the account.

Mortality also can be guaranteed, which provides for the payment of annuity benefits for life.

Occasionally, you may decide that it's in your parents' best interest to purchase an annuity that offers some guarantees but also offers protection against inflation. This type of annuity usually is identified as a combination or balanced annuity.

Both sorts of annuities may be purchased with a single payment, or your parents can make periodic payments. A single-premium or single-payment annuity usually is purchased with money transferred from some other investment.

Example: Your parents convert a 20-year-old cash-value life insurance policy into an annuity that pays them a set amount each month soon after they retire. The advantage of this conversion is the deferral of any taxes that would be owed on the cash value if it were paid out in a lump sum.

Variable annuities also may be purchased with a variable-premium feature, known as a flexible-premium deferred annuity (FPDA) contract. Like variable universal life insurance, this type of annuity allows your parents to pay as much or as little as they like during each premium period -- though there's usually a minimum payment required.

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