Annuities offer a tax-deferred retirement income stream for life. This strategy has several sub-types with their respective pros and cons that vary based on your retirement plans.
This guide covers the sub-types of fixed annuities, rates, pros and cons, and comparisons versus the other types of annuities.
What is a Fixed Annuity?
An annuity creates a steady income for life – a secure investment.
As such, most people use annuities as part of their retirement plan. It can take a volatile vehicle, such as a 401(k) invested in the stock market, and protect it. You can’t lose your retirement nest egg in a market downturn. It doesn’t matter what the market does. You will always receive that income.
Annuities function as a hedge against bad luck and back timing. Say the stock market crashes, like it did in 2008, a year or two before you retire. It can take years to rebuild what you had – especially if your 401(k) management company gets nervous and sells low. Many people saw their portfolios reduced to a fraction of what they were worth and had to delay retirement if they could.
In the case of an annuity, the insurance company assumes the risk for the rest of your life.
Fixed annuities also create a safety net in case you outlive your money – one of the top concerns of soon-to-be retirees.
Fixed Annuity Definition
Annuities come in several types. Some have term payments. Others have variable growth rates – you can gain massively, but also risk losing your principal.
A fixed annuity is a contract with an insurance company. You make payments in a lump sum or over time. Then you wait while the 8th world wonder of compound interest grows your money. The industry calls this the accumulation phase. You choose the date it switches from the annuitization phase to the payout phase when you create the contract.
Think of it as the life stages of a butterfly. The first part where you’re funding the annuity is the caterpillar, building up the energy to build a cocoon. The cocoon is the annuitization phase – growth. Then the butterfly emerges once the contract begins to payout.
The term ‘annuitant’ refers to the person who will receive the payouts from the contract.
Types of Fixed Annuities
If every insurance product were the same, we wouldn’t need agents or books to make sense of them. Several sub-types of fixed annuities offer various benefits depending on what an annuitant needs it to do.
Straight life – the most straightforward of fixed annuities. The insurance company makes payments until the annuitant passes away. If the annuitant passes earlier than expected, the insurance company keeps the remainder of the money. If the annuitant lives an exceptionally long life, the insurance company keeps paying – indefinitely.
Substandard health – designed for people with health concerns affecting longevity. It has much higher payouts than straight life. However, the premiums cost more. This happens because the insurance company has less time to build up the return on investment.
Life with a guaranteed term – a hedge against losing the principal if the annuitant passes away early. Some people distrust the principle of annuities because the insurer keeps the money if the annuitant doesn’t live as long as expected. Adding a guaranteed term means if the annuitant does pass on early, a beneficiary receives the remaining amount. The annuitant must pass away within the designated term for this clause to kick in.
Joint life – an annuity for couples. This annuity pays until both annuitants pass. It costs more than straight life because it involves two lifespans. Also, married couples tend to live longer – increasing the expected lifespan.
There is a common point of confusion in joint life to keep in mind. Some people get the impression that it pays each person. The terminology is confusing at first. Joint life will pay the same about each month from the start of the payment phase until the 2nd spouse passes on.
Using Fixed Annuities to Your Advantage
Most people set up their annuities as they near retirement. The strategy shifts your retirement funds to increasingly secure, albeit low-interest, investments the closer you are to the end of your working years. There is no sense in working hard your entire life only to watch your retirement portfolio come crashing down through means outside of your control, right?
Look at the fixed costs for your retirement. What do you expect to spend each month? Many soon-to-be retirees choose to set up their annuities so that the annuity payments cover their basic cost of living. That way, no matter what happens, the basics get covered, and they cannot outlive their money.
The type of annuity you choose will depend on your risk tolerance. If you want the security of knowing that you will never lose your principal, a fixed annuity offers a great choice.
Fixed Annuity Rates
The big advertisements for fixed annuity rates currently sit around 3.6%. This varies from year to year, partially depending on how well the insurance company thinks they can invest your money.
You might find some annuities closer to the 4% range and others down in the 1.5% range.
One pitfall to watch is that many fixed annuities start at a higher rate (say 3.6%) then drop down to the lowest guaranteed rate after the introductory period.
Naturally, you’ll find the details on the lowest guaranteed rate in the fine print. Check the details in the contract to see what the minimum guaranteed rate is on any prospective annuity.
These guaranteed rates vary widely by insurer. An agent can use their experience with annuities to tell you which companies tend to maintain higher rates and which look better on paper.
It’s in everyone’s best interest to find you the best annuity possible—yours for obvious reasons. But an agent won’t stay in business very long if their clients end up regretting their annuities five years down the line. It’s in their best interest to keep you wealthy for the rest of their life.
It’s in everybody’s best interest not to rush through the comparison shopping phase for annuities.
Pros of Fixed Annuities
Fixed annuities count as tax-deferred investments. While they’re growing (accumulation phase), you don’t pay any taxes. You use after-tax dollars to fund it so you would only owe the IRS taxes on the interest. You don’t pay any of these taxes until the payout phase, and then, only on the distributions for the year.
Fixed annuities create an income stream for life. They mitigate the risk of outliving your money – which is one of the top worries for most everyone approaching retirement. Did I save enough?
The biggest advantage is a fixed annuity is about as secure as you can get from an investment, short of having cash in an FDIC insured account. The risk factor comes from the financial stability of the insurance company.
If a company’s financial rating sits in the A category, go for it. B ratings open you up to a little more risk. If you’re choosing an annuity for security reasons, stick with A-rated companies and keep your riskier investments elsewhere.
Cons of Fixed Annuities
Most investors look for higher rates of return than what fixed annuities offer. You’re trading security for minimal growth.
Monthly payments may not keep up with inflation. Each year, the spending power of the dollar decreases a little. If you retire at 67 and live to 97, that’s a significant difference in what a dollar will buy you over time.
One way to mitigate this is to factor in how your cost of living will likely increase as you get older. Consider balancing these numbers when you choose your annuity payment amount.
The financial solvency of the insurance company also bears consideration. While we’ve seen government bailouts demonstrating an interest in keeping the larger insurers solvent, it’s not a guarantee that will happen in the future. That’s why it’s doubly important to make sure the insurance company offering your annuity has an A-rating for financial stability. If the company goes under, no more annuity payments are coming.
Fixed Annuity vs. Variable Annuity
A variable annuity invests those premiums during the accumulation phase. There is no guaranteed growth, but there also isn’t a limit.
This does two things. First, you have higher growth potential. If the market does exceptionally well, your annuity will grow fast. But it also exposes the principal to risk.
For example, anyone whose variable annuity was in the accumulation phase in 2008 most likely watched it tank. They may have even lost some of the principal when the market crashed.
Variable annuities can also charge extra fees for the investment management of what’s in the market. Make sure to factor this into your calculations.
Fixed Annuity vs. Fixed Index Annuity
A fixed index creates a happy medium between a variable annuity and a fixed annuity. It ties the growth to an index (like the S&P 500) but does not directly invest the money.
Most companies offer a 0% floor – you can’t lose your principal or growth-to-date. At the same time, fixed index annuities have a growth ceiling or participation percentage. The ceiling usually limits growth to around 5%. Participation rates typically fall between 50% and 80%. For example, if you had an 80% participation rate and the market grew 10% that year, you would see 8% interest.
A fixed index annuity offers the potential for more growth but at a less stable rate. It’s designed for people who have higher risk tolerance.
If a fixed annuity sounds like it might be something sensible for your retirement planning, you’ll want to find an agent you like with experience in annuities. They can take the specifics of your retirement goals into account, crafting the ideal annuity for your situation.