A fixed annuity is the simplest and easiest type of annuity. They also typically provide the most predictable and reliable income streams with the lowest fees.
A fixed annuity can be immediate or deferred, which depends on your contract. According to your contract, you may start receiving annuity payments within one year of purchasing your fixed annuity or you may start receiving payments later. Deferred annuities generally begin to pay at retirement.
When deciding whether a fixed annuity is right for you, you should consider how it works and how it compares to other types of annuities.
What is a Fixed Annuity?
A fixed annuity is a contract between you and the insurance provider. It can act as a safe haven for cash to defer interest taxes.
You pay for a steady stream of income, and in return, the insurance company guarantees a minimum interest rate on top of your principal.
Your contract will specify how the money grows in your fixed annuity. It can be through a set dollar amount, interest rate, or other formula specified in the contract.
Income payments from a fixed annuity can be guaranteed for life, commonly known as a life annuity or single-life annuity, or for a number of years depending on the terms of the contract specifying the annuity payment options. An annuity contract that pays income benefits for a certain number of years is called a definite annuity or term definite annuity.
You can also choose to receive the annuity income benefits as a lump sum.
How does a fixed annuity work?
Investors can buy a fixed annuity that consists of a lump sum or a series of periodic payments. The insurance company, in turn, guarantees that the account will earn interest at a certain rate. This period is called the accumulation stage.
When the annuity owner, or the annuitant, chooses to receive regular income from the annuity, the insurance company calculates that payout based on the amount in the account, the owner’s age, for how much duration the payments are to resume, and other factors. This starts the payment phase. The payment phase may continue for a specified number of years or for the rest of the owner’s life.
During the accumulation stage, the account evolves tax-deferred. After the account holder annuities the contract, the distributions are taxed based on the exclusion ratio. This is the ratio of the account holder’s premium payments to the amount accumulated in the account based on the interest earned during the accumulation phase. The premiums paid are excluded and the portion attributable to the benefit is taxed. This is often represented in form of percentages.
This situation applies to non-qualified annuities, which are not held in a qualified retirement plan. In the case of a qualified annuity, the entire payment will be subject to tax.
Types of fixed annuity
Fixed annuities can be divided into three broad types: traditional, indexed, and multi-year guaranteed.
A traditional fixed annuity, also known as a guaranteed fixed annuity, accumulates money based on a fixed interest rate determined at the beginning of your contract.
Prevailing interest rates determine the starting rate for fixed-income investments. The rate on your contract may be the same or higher than the rates on certificates of deposit (CDs) or government bonds.
Insurance companies may increase the interest rate on your traditional fixed annuity contract after a certain period of time, such as two years. The new interest rate cannot be below the minimum rate defined in your contract.
When shopping for a traditional fixed annuity, it’s essential to discover one that provides a competitive interest rate.
For example, some insurers may offer renewal rates slightly above the contract’s guaranteed minimum. Relatively low-interest rates may struggle to keep pace with inflation over time.
Be sure to carefully compare contract details before choosing a traditional fixed annuity.
Fixed Index Annuity
A fixed index annuity is connected to the performance of an underlying index, like the S&P 500 or the Dow Jones Industrial Average.
This annuity limits both your potential losses and gains.
You won’t lose any money you put into a fixed index annuity unless you withdraw the money or surrender the contract.
Not only will you lose your capital if the market goes down, you’ll also miss out on big upswings.
A fixed index annuity caps the market’s potential upside. As a result, you may not earn as much in strong years as you would if you invested directly in the stock market.
Fixed index annuities use several measures to control your gains and losses, including return limits and participation rates.
Multi-Year Guaranteed Annuity (MYGA)
A multi-year guaranteed annuity, or MYGA, is another kind of fixed annuity, which is similar to a traditional fixed annuity. The only actual difference is the length of the assured rate.
The interest rate for MYGA is guaranteed for the entire term of the agreement. There is no risk that the insurance company will change the rate at which your money grows over time.
You can think of an MYGA like a fixed-rate mortgage: the rate is locked in and won’t go up or down for any reason.
In contrast, other fixed annuities only guarantee an initial rate for a specific portion of the contract.
Imagine you buy a 10-year traditional fixed annuity at a 4% interest rate. The rate will be locked in only for a certain period of time, such as the first five years. After that, depending on the terms of your contract, the rate may increase or decrease.
Meanwhile, the MYGA variation guarantees a 4% rate for the entire 10-year term.
Who should have a fixed annuity?
Fixed annuities can be an attractive option for conservative investors planning for retirement because these products provide a predictable stream of income. People know the interest rate their money will earn and how long they will earn this rate.
Another way to supplement later life expenditures can provide peace of mind to people who value safety and stability rather than looking for high stock market returns.
Fixed annuities are more predictable and less complicated than other types of annuities such as variable annuities.
This type of annuity is best suited for investors who want to preserve their principal — but who want their money to grow faster than a savings account or CD can provide.
Accumulation and Payment
A fixed deferred annuity has two distinct stages: accumulation and payout.
After you decide to buy a fixed deferred annuity, the insurance company sets up an agreement to pay you a minimum amount of interest while your account is growing. This is called the accumulation stage.
During this stage, the present interest rate is applied. This annuity rate is assured for that duration.
Deferred taxes accrue during the interest accrual stage in your account.
The payout stage begins when you receive regular income from your annuity. Depending on your contract, you can choose to receive payments for a set number of years or for the rest of your life.
Benefits of fixed annuity
Fixed annuity owners can benefit from these contracts in various ways.
Estimated investment returns
Rates on fixed annuities are derived from the yield a life insurance company receives from its investment portfolio. A life insurance company invests primarily in high-quality corporate and government bonds. The insurance company is then liable to pay whatever rate is promised in the annuity contract. This contrasts with variable annuities, where the annuity owner chooses the underlying investment and therefore assumes most of the investment risk.
Guaranteed minimum rates
Once the initial guarantee period in the contract is over, the insurer can adjust the rate based on the stated formula or the yield it earns on its investment portfolio. As a measure of protection against falling interest rates, fixed annuity contracts usually include a minimum rate guarantee.
Because a fixed annuity is a tax-qualified vehicle, its earnings growth and the compounding is tax-deferred; Annuity owners are taxed only when they take money out of the account, either through occasional withdrawals or as regular income. This tax deferral can make a significant difference in how the account builds up over time, especially for those in higher tax brackets. The same is true for qualified retirement accounts like IRAs and 401(k) plans, which also grow tax-deferred.
Guaranteed income payouts
A fixed annuity can be converted into an immediate annuity at any time when the owner chooses. The annuity will then generate guaranteed income payments for a specified period or for the life of the annuitant.
The relative safety of the principal
The life insurance company is responsible for protecting the money invested in the annuity and fulfilling any promises made in the contract. Annuities are not officially insured like bank accounts. For this reason, buyers should only consider doing business with life insurance companies that receive high grades for financial strength from major independent rating agencies.
Criticisms of fixed annuity
Annuities, whether fixed or variable, are relatively liquid. A fixed annuity typically allows one withdrawal per year of up to 10% of the account value. This makes them ineligible for funds that the investor may need in a sudden financial crisis.
During the surrender period of the annuity, which can last up to 15 years from the inception of the contract, withdrawals in excess of 10% are subject to a surrender charge imposed by the insurer.
Annuity owners who are under the age of 59½ may also have to pay a 10% tax penalty in addition to regular income tax.
Finally, annuities often carry higher fees than other types of investments. Anyone interested in an annuity should make sure they understand all the fees involved before committing. It also pays to shop around because fees and other terms can vary widely from one insurance company to another.
What decides a fixed annuity rate?
Unlike variable annuities and indexed annuities, fixed annuities are not connected to stock market returns or other investments.
Instead, your money grows at an interest rate set by the insurance company.
When an insurance company gets your funds, it adds them to its general account pool of incoming premiums. The company then invests those funds, usually in government securities or high-quality corporate bonds that make a little higher interest rate than the insurance company pays you.
Your fixed annuity contract will have a minimum assured rate. A guarantee from the annuity company is that the interest on your fixed annuity will not fall below that rate. The company also assures the principal amount.
Certain types of fixed annuities, such as multi-year guaranteed annuities, lock in the same rate for your entire contract. Others may adjust the interest rate after a certain period of time.
After the end of the fixed time period, another interest rate, known as the renewal rate, is applied. You can request your agent or broker to provide a renewal rate table to get an idea of what to expect. However, even if the interest rate is adjusted from time to time, it cannot fall below the guaranteed minimum rate specified in your contract.
Is a fixed annuity guaranteed?
In general, annuity funds are not guaranteed by the Federal Deposit Insurance Corporation or any other federal agency. They are regulated and guaranteed by the State Insurance Commission.
An annuity is just as secure as the insurance company that offers it. While it is highly unlikely that an insurance company will go bankrupt, it is important to choose an insurer having an A rating from one of the major insurance rating agencies, like Fitch or AM Best.
FINRA advises anyone shopping for an annuity to contact their state insurance commissioner to make sure their broker is registered and authorized to sell annuities in the state.
Regulatory nonprofits also suggest whether or not your state has a guaranty association that will protect you if your insurer goes bankrupt.
Fixed annuities and CDs
A certificate of deposit, or CD, is a savings security with a fixed interest rate and a specific withdrawal date, known as the maturity date.
Like a CD, a fixed annuity pays a guaranteed interest rate for a specified period of time, such as three to 10 years.
Fixed annuities and CDs are similar in that you are guaranteed to get back your principal investment after a certain amount of time — plus a certain amount of interest.
Similarities between fixed annuity and CD
- Both are considered low-risk investments.
- Both offer different accumulation periods. However, Cd accumulation phases are short.
- Both protect your principal.
But there are many differences between fixed annuity and CD.
For example, CDs are usually purchased through a bank or credit union, while annuities are purchased from an insurance company.
Fixed annuities often offer similar or slightly higher interest rates than CDs. Fixed index annuities, which are linked to the performance of the underlying stock index, offer higher returns than CDS.
According to Forbes, the long-term expected return on a fixed index annuity is higher than on a CD.
Differences between fixed annuity and CD
- CDs are usually purchased from banks or credit unions. A fixed annuity is purchased from an insurance company.
- Interest earned on a fixed annuity is tax-deferred while CD interest is taxed as ordinary income for the year it is earned.
- CDs will attract high penalties if you withdraw money before the maturity date. With fixed annuities, many insurance companies allow you to withdraw up to 10% of your account value without a surrender charge. Yet, additional annuity penalties may apply.
Fixed annuities can also offer more attractive tax benefits than CDs.
Unless a CD is purchased in an IRA or other retirement account, the interest it earns is subject to federal and state income taxes each year.
Conversely, interest earned within a fixed annuity is tax deferred. You don’t pay tax on it until you withdraw the interest.
Ans: A fixed annuity is the least expensive type of annuity. Carriers levy commissions and may charge transfer fees, administrative charges, or underwriting fees. Make sure to read your contract carefully and inquire about all charges and commissions.
2. Can you lose your funds in a fixed annuity?
Ans: You won’t lose money in a fixed annuity as long as you hold the contract to maturity and don’t withdraw early. Withdrawing money from a fixed annuity too soon can result in penalties and fees.
3. How are fixed annuity rates decided?
Ans: Fixed annuity rates are set by insurance companies and take into account certain factors, including the premium amount, current interest rates, the age and life expectancy of the annuitant, and the gender of the annuitant.