Understanding Fixed Annuities
A fixed annuity is a contract between you and an insurance company that guarantees a specific interest rate on money. Unlike variable annuities, which are tied to the stock market and can fluctuate, fixed annuities offer predictable, set interest rate. This makes them a popular choice for retirement planning.
How Does a Fixed Annuity Work?
You can purchase a fixed annuity from an insurance company either with a single lump sum or through a series of payments. In return, the insurer guarantees that your deposit will earn a fixed interest rate. The terms of the interest rate and how it changes over time will be specified in your contract. Typically, fixed annuity rates are guaranteed for a set number of years and may adjust periodically based on current rates.
The guaranteed minimum interest rate for fixed annuities usually ranges between 1% and 2%. However, the best fixed annuity rates are often above 2%, with insurance companies potentially paying a higher interest rate than the guaranteed minimum. In todays interest rate environment guaranteed rates are closer to 5% and 6%.
Types of Fixed Annuities
- Immediate Fixed Annuities: Begin paying out within a year of signing the contract.
- Deferred Fixed Annuities: Payments begin at a future date, often during retirement.
Benefits of Fixed Annuities
Predictable Returns
Fixed annuities offer the simplest form of annuity with predictable returns. Unlike variable and indexed annuities, the returns aren’t tied to the stock market, providing peace of mind and financial stability.
Lower Risk
While no investment is entirely risk-free, fixed annuities offer greater security than many other options. They protect your money from market fluctuations, which is especially crucial during retirement when taking significant financial risks is not advisable.
Tax-Deferred Growth
Earnings within a fixed annuity grow on a tax-deferred basis. You only pay taxes when you withdraw the money or start receiving regular payouts. This is a significant advantage, similar to the tax treatment of traditional 401(k) plans or IRAs.
Strong Guarantees
Annuities are backed by the National Association of Insurance Commissioners (NAIC), which provides stronger guarantees than the FDIC. This means that even if the issuing insurance company fails, your annuity benefits are better protected, offering greater peace of mind compared to bank-backed products.
Guaranteed Income Payments
The insurance company is obligated to honor the guarantees and promises outlined in your contract. If you opt for lifetime payments, the insurer must provide these payments as agreed, ensuring a steady income throughout your retirement.
Drawbacks of Fixed Annuities
Illiquidity
Fixed annuities are not very liquid, meaning accessing your money quickly in an emergency can be challenging and may involve significant fees and penalties. Changing your mind after signing the contract can also be difficult. Most fixed annuities do allow for a free withdrawal of 5% up to 10% of the accumulated value per year.
Lower Returns
While fixed annuities generally offer a higher guaranteed rate than certificates of deposit (CDs) from banks or credit unions, the returns are still relatively modest. Because the growth rate is fixed, your earnings might not keep pace with inflation, potentially reducing your purchasing power over time.
Additional Drawbacks
- Surrender Charges: Withdrawing more than 10% of your account during the accumulation phase may result in surrender charges.
- IRS Penalty: Withdrawing money before the age of 59.5 may incur a 10% penalty from the IRS because annuities are considered retirement accounts.
- Issuer Risk: The guarantees are only as strong as the issuing insurance company. If the insurer fails, your annuity could be at risk.
- Inflation Risk: Without a cost of living adjustment rider, your fixed annuity payments may not keep up with inflation.
- Growth Potential: Fixed annuities offer lower growth potential compared to other investment options.
Conclusion
Fixed annuities can be a valuable component of a retirement strategy, offering predictable, low-risk income. However, they come with limitations such as illiquidity, lower returns, and potential inflation risk. It’s essential to weigh these pros and cons carefully to determine if a fixed annuity aligns with your financial goals and retirement needs.
For personalized advice, consider consulting with a financial expert. Visit our “Connect with a Financial Professional” section to find the right advisor for your needs. For a personal referral to an independent, licensed advisor, call us at 877-476-9723 or contact us here to schedule your initial consultation.
🧑‍💼Authored by Brent Meyer, founder and president of SafeMoney.com, with over 20 years of experience in retirement planning and annuities. Learn more about my extensive background and expertise here
