Annuities are a growing solution for people wanting financial stability and protection, especially in their retirement years. While all annuities can pay a steady, guaranteed income stream for life, fixed-type annuities can be appealing at times when markets are chaotic and economic conditions are uncertain. They offer the benefit of principal protection.
Of course, if you are considering a fixed annuity as part of your financial plan, you may wonder about the risks tied to owning one. After all, annuities are supposed to be a tool for managing risk, right? Who assumes the investment risk with a fixed annuity contract?
In this article, we will cover this question in depth, but here is a quick answer. The life insurance company standing behind the fixed annuity contract bears the investment risk. The insurer pools this risk across thousands of annuity contract holders, including you, and manages this risk in a variety of ways so that it can make good on its promises to you and everyone else. Life insurance companies have a strong record of fulfilling their contractual promises in good and bad economic times.
Before we take a deeper dive into fixed annuities and how insurance companies stand behind the investment risk of upholding them, let’s delve more into fixed annuities and what they involve.
Understanding Fixed Annuities
Here are the quick basics of how a fixed annuity works. Think of it as a contract that a life insurance company makes with you.
In exchange for certain assurances from the life insurance company, you give the insurer a lump sum of money. The insurance company usually promises to give you a series of payments later on, often during your retirement. You can receive this stream of payments for a certain timespan or for the rest of your life.
Now, all types of annuities can pay a guaranteed income stream, but fixed-type annuities stand out for other reasons. Fixed-type annuities are called “fixed” because of how the life insurance company guarantees that your principal won’t be lost regardless of how the stock market or other market conditions perform.
Fixed-type annuities include traditional fixed annuities, multi-year guarantee annuities (MYGAs), and fixed index annuities. With traditional fixed annuities and MYGAs, the insurance company promises to pay you a set amount of interest on your money over a certain time period. So, for example, if you had a MYGA with a 3-year term and a guaranteed 3% rate, your money would grow at three percent annually over the term.
With a fixed index annuity, the growth isn’t guaranteed. Instead, your money can earn interest that is based on the movements of an underlying financial benchmark index, such as the S&P 500 index. Over time, money inside a fixed index annuity may earn more interest than it would inside a fixed or MYGA annuity.
Fixed index annuities do include an option for an annual, guaranteed fixed rate, but most people buy these annuities for the interest-earning potential tied to an index or for other specific benefits, such as an income rider.
The biggest benefit of a fixed annuity is you will know exactly what you will get, how much you will get, and when you will get it.
The Insurance Company Assumes the Investment Risk
The great news for fixed annuity owners is that the investment risk falls on the insurance company, not on your shoulders. That being said, keep in mind that your annuity guarantees depend on the insurance company’s ability to meet those obligations. In industry-speak, we call this the financial strength and the ability of the insurance company to pay its claims. You can tell more about this from a life insurance company rating, among other things.
Now, here is more on why the investment risk of a fixed annuity contract falls on the insurance company.
Guaranteed Growth in Good and Bad Times
Remember how we mentioned that your money has guaranteed growth with a plain-vanilla fixed annuity or MYGA annuity? Well, the key here is that the insurance company offers you a fixed interest rate. This means they promise to pay you a specific amount of interest on your money, and they can’t change it once the contract is in place.
This fixed interest rate is like a safety net for you. Even if the economy takes a nosedive or financial markets go through a rollercoaster ride, your interest rate is guaranteed by the insurance company to remain the same. And again, it’s not completely foolproof, but insurance companies have a very strong record of delivering on their promises in good and tough economic times.
During the annuity payout phase – or when you turn on those regular income payments – the insurance company also guarantees that you will receive the promised payout amount. This guarantee can bring much peace of mind because, once again, you don’t have to worry about market ups and downs affecting your income.
Managing Market Risks
Now, you might wonder, “What about the insurance company? How do they manage the investment risk?” Well, insurance companies are skilled experts in this area.
They take a long-term view of the risk and their management of it. They support their annuity obligations by investing your money in underlying investments that help them cover their promises to you while still making a profit.
Most of the cents in every dollar of fixed annuity premium are put into government bonds, securities, corporate bonds, and other stable assets, which are considered less volatile than stocks. This way, the insurance company can ensure they have enough money to make those ongoing payments to you, regardless of how the stock market behaves.
Benefits and Limits of Fixed Annuities
So, the insurance company holds the investment risk with a fixed annuity contract. That makes sense, as annuities are transfer-of-risk plays.
But what could having a fixed annuity mean for you as the annuity owner? Let’s now look at the benefits and limits of a fixed annuity.
Benefits of a Fixed-Type Annuity
- Steady Income: Fixed annuities provide a reliable source of income during your retirement years.
- Predictable Stream of Money: With the annuity, you know exactly how much money you will receive, making income planning for retirement easier.
- Lower Risk: Since the insurance company takes on the investment risk, you can enjoy a higher sense of financial security.
- Tax Advantages: Some fixed annuities offer tax-deferred growth, meaning you don’t pay taxes on the interest you earn until you withdraw the money.
Limits of a Fixed-Type Annuity
- Lack of Flexibility: Fixed annuities aren’t very flexible. Once you commit your money, it’s challenging to access it without penalties.
- Inflation Concerns: Most fixed-type annuities pay fixed amounts, which might not keep pace with inflation, potentially reducing your purchasing power over time.
- Annuity Fees: Traditional and MYGA annuities don’t really come with fees, but some fixed index annuities do, depending on what add-on benefits they offer, among other things. As a long-term vehicle, annuities also come with surrender charges for early, excessive withdrawals or contract exits. Talk to your financial professional and make sure that you understand everything involved.
- Limited Growth Potential: While fixed annuities offer stability, they might not provide the same level of growth potential as investments or instruments of greater risk.
Consider Your Financial Goals
A fixed annuity contract can be a helpful foundation as part of your overall retirement financial plan. Before committing to a fixed annuity, it’s essential to consider your financial goals and needs. What do those look like, and how will the annuity help solve gaps in your current plan?
To work through this, here are a few questions to ask yourself:
- What are your retirement goals? Do you want a reliable source of income during retirement, or are you looking for more growth potential?
- How risk-averse are you? Are you comfortable with market ups and downs, or do you prefer a stable, low-risk investment? What is your risk capacity, or the maximum amount of risk, mathematically speaking, that your investments can take before they are unable to recover?
- What are the fees and terms? Make sure you understand any fees associated with the annuity contract and the terms of the contract.
- Is inflation a concern? Consider how your annuity interest earnings and fixed payouts will keep up with inflation over the long run. How will the rest of your financial plan help your income keep up?
- Do you have other retirement savings? Think about how fixed annuities fit into your overall retirement savings strategy. They can be a valuable part of a diversified retirement plan.
The Bottom Line on Fixed Annuity Contracts and Investment Risk
In a fixed annuity contract, the investment risk falls mainly on the insurance company, not on the individual annuity owner. This can help people have a sense of security and predictability, making fixed annuities an attractive option for those seeking a reliable source of income during retirement.
However, it’s essential to weigh the benefits and limits of fixed annuities against your financial goals and risk tolerance. Just as with any financial decision, having a fixed annuity contract should be part of a well-thought-out retirement plan. The annuity needs to solve a clear problem in your plan, and it needs to line up with your needs, goals, risk tolerance, and financial situation.
Talk to your financial professional for more information on fixed-type annuities, what they can offer, and your current progress in retirement planning. If you are looking for a financial professional to help you, many independent and experienced financial professionals can assist you here at SafeMoney.com.
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