What Is a Fixed Annuity? Investment Benefits and Disadvantages

A fixed annuity is a long-term investment that provides a predictable income stream. Offered by insurance companies, banks and other financial institutions, it guarantees a fixed interest rate and steady payouts. This predictability makes fixed annuities a popular choice for individuals seeking a stable and secure income source in retirement.

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How Fixed Annuities Work

Here’s a breakdown of how fixed annuities work.

Basics of Fixed Annuities

Think of a fixed annuity as a contract between you and the insurance company, bank or other financial institution. You pay the insurer a lump sum, or a series of payments. In return, the insurer agrees to pay you an agreed-upon amount in a certain amount of payments, either right away or in the future. The payments include interest and can be for a limited amount of time or for the rest of your life.

The key elements of a fixed annuity include:

• Principal investment: The initial amount you invest.

• Fixed interest rate: The guaranteed rate of return on your investment.

• Payout period: The schedule and duration of payments, which can range from a few years to your entire lifetime.

The insurance company manages the annuity funds to ensure that your principal is safe and provides the promised payments. This is why you want to choose the insurer carefully.

Fixed Interest Rates

People like fixed annuities because they offer stability and predictability. The interest rate that you earn during the accumulation phase — the time between when you pay premiums and when you begin receiving payments. — does not change. This means that you know exactly how much your payments will be, no matter what the markets or the economy do. It also ensures consistent growth.

Of course, for receiving this stability, you give something up in return: if interest rates rise in the future, you are stuck with the interest rate you and the insurer agreed upon when you made the contract. On the other hand, if rates fall, you still receive your agreed-upon rate and come out ahead.

These annuities also have a tax benefit. Your money grows tax-deferred, meaning you do not pay taxes on it until you begin receiving payments. If you plan on being in a lower tax bracket when you receive payments, such as during retirement, it could save you money in taxes.

Types of Fixed Annuities

Understanding the different types of fixed annuities can help you choose the right one for your needs.

Immediate Fixed Annuities

With these annuities, you make a single lump sum payment. After that, you begin receiving payments immediately for the rest of your life, or a set number of years. These can be set up for an individual, or jointly, for a couple. Immediate fixed annuities are normally irrevocable, so you cannot surrender the annuity for the contract value.

These might be good for those entering retirement who want peace of mind, knowing that they will have a fixed income for the rest of their life. For this reason, you want to consider it carefully. 

Deferred Fixed Annuities

Deferred fixed annuities let you pay premiums now, in a lump sum or in payments. Your money will grow in the account at a fixed interest rate. Then later, for example during retirement, you receive payments.

You do not pay taxes on the money until you receive payments. This means that, properly planned, you are in a lower tax bracket when you receive the money as income. And because the interest rate is fixed, your rate of return is fixed.

Two terms to know about deferred fixed annuities:

• Accumulation phase: This is the period between when you make your premiums or lump sum payment and when you receive your payments. During this time, your investment grows tax-deferred, meaning you won’t pay taxes on the interest until you withdraw it.

• Payout phase: This is the period when you receive regular income payments, either for a fixed period or for life.

You might want to consider a deferred annuity if you are still working and want to grow your savings while securing future income.

Fixed Annuity Example

Here’s a step-by-step example to see how a fixed annuity works in practice by calculating the interest year-by-year. With compounding interest, the growth can be more significant over time:

• Initial investment: $100,000

• Fixed interest rate: 3% annually

• Time period: 10 years

• Year 1: $100,000 x 3% = $3,000 (interest earned).

• Year 2: $103,000 x 3% = $3,090 (interest earned).

• Year 3: $106,090 x 3% = $3,182.70, and so on.

After 10 years, the total value of the annuity would grow to approximately $134,391. This consistent growth can supplement retirement income, while avoiding stock market risks.

The other advantage is through taxes. For instance, because of tax deferral, there is more money earning interest during the accumulation phase, thereby generating more interest than money that is taxed during that time.

How Fixed Annuities Compare To Other Annuities

There are important differences between fixed annuities and other kinds of annuities, such as variable rate annuities and indexed annuities.

Fixed vs. Variable Annuities

With a variable annuity, rather than your interest rate being fixed for the duration of the contract, the interest rate is variable, meaning it is dependent on an agreed-upon market rate. So it can change, up or down, during the contract, thereby resulting in greater or lesser payments.

• Risk: Fixed annuities offer a fixed interest rate that never changes. This means they give you guaranteed returns. Variable annuities have an interest rate that can change depending on market performance and therefore carry higher risks.

• Return: Fixed annuities prioritize stability over potential higher gains, and for that reason, they offer modest returns. Variable annuities have the potential for higher returns but they give no guarantees.

• Flexibility: Fixed annuities usually offer fewer choices. But they also come with low fees. Variable annuities often allow for more customization, but they also carry higher fees because of management costs.

Fixed vs. Indexed Annuities

An indexed annuity is one where all or some of the interest rate is tied to a market index, such as the S&P 500 or the Dow Jones. This makes it easy for you to know if your interest rate is increasing or not by simply checking the markets.

• Market link: Even though your annuity is based on a market index, it is not invested in the stock market. Therefore, even if the market goes down, your principal is not lost.

• Guarantees: Fixed annuities provide guaranteed returns, while indexed annuities offer limited guarantees based on the performance of the market index it is linked to.

How To Buy a Fixed Annuity

Buying an annuity is a big financial decision that can have major ramifications on your future financial stability and health. Here are some pointers to know.

Choosing a Provider

Because you will likely be counting on future payments as a substantial part of your income, you want to make sure the institution you choose is reputable and robust. Here are a few things to consider:

• Compare providers: There are many companies selling annuities, each with its unique profiles, histories and products. So it pays to shop around.

• Financial strength: Check ratings from agencies like AM Best, Fitch or Moody’s. They rate annuities from A++ and A+ (Superior) to D- (Poor).

• Reputation: Look for reviews, recommendations and companies that have a long history in the business.

• Fees: Understand any administrative costs, surrender charges or commissions. If an annuity does charge higher fees than another, make sure the benefit is worth it.

Understanding Terms and Conditions

When it comes to fixed annuities — or any annuity for that matter — you might want to read the fine print. The terms and conditions will detail the ways you can access your money, any fees and other crucial information. Remember, this is a major decision, so take some time now to fully understand it.

Some things to pay special attention to are:

• Surrender rights: This is the length of time before you can withdraw any money without any penalties. Make sure you know your rights in this area.

• Payout options: There are two major types of payouts: a fixed term with a set amount of payments or payments for the rest of your life. Make sure you know which you prefer and are signing up for.

• Death benefits: If you require it, make sure the annuity provides benefits to your heirs.

• Interest rate: Is the interest rate fixed or variable? Is it the highest you can get for the type of policy you choose?

Alternatives To Fixed Annuities

Fixed annuities are not the right choice for everyone. That’s why there are so many alternatives to them. You owe it to your future self to consider any that you believe fit your long-term financial goals and risk tolerance.

Here are a few common alternatives to fixed annuities:

• Certificates of deposit: These are deposit accounts that are FDIC insured. They offer a fixed interest rate for a specific period of time, in exchange for you agreeing not to withdraw your money for the term.

• Bonds: These are loans you make to a government or business, which guarantees to pay you the principal plus interest back over time.

• Savings accounts: These typically offer lower interest rates and are normally variable.

FAQ

Here are the answers to some of the most frequently asked questions regarding fixed annuities.

• What is the minimum investment for a fixed annuity?

  • Minimums vary greatly by provider, but the minimum investment is usually in the thousands. Some have minimums as low as $1,000.

• Are fixed annuities a good choice for young investors?

• How does inflation impact fixed annuities?

  • Fixed annuities do not adjust for inflation. So inflation can dig into your returns. There are some annuities that adjust for inflation. If you are worried about inflation rising sharply, you could consider them.

• Can I withdraw money early from a fixed annuity?

• Are fixed annuities safe during market downturns?

Elizabeth Constantineau contributed to the reporting for this article.

This article originally appeared on GOBankingRates.com: What Is a Fixed Annuity? Investment Benefits and Disadvantages