Are you looking for an effective way to manage your retirement income? If so, then you may want to consider an annuity. Why? It will provide regular and guaranteed payments, similar to those from a pension plan. In fact, 9 in 10 investors, according to the Protected Retirement Income and Planning Study conducted by ALI and CANNEX, want their retirement income plan to guarantee a guaranteed income or protect their principal.
But why is this so important? First, due to their predictability, investors who want to supplement other investments and retirement income streams with a guaranteed income stream prefer annuities, specifically fixed annuities. Also, fixed annuities provide peace of mind since market fluctuations don’t affect their performance.
“Our research demonstrates that there’s been a real ‘retirement reset’ in people’s minds over the past year,” says Cyrus Bamji, ALI’s head of communications. “BLS estimates that approximately 3 million Americans retired during the pandemic, which is double what was projected before the pandemic.
With that information comes the realization that retiring earlier means you have to fund a longer retirement. That reality has set in for Americans and has led people to take a hard look at the amount of risk and expected income in their retirement plans and investment portfolios.”
Bamji added, “these trends have led to more consumers realizing that a retirement plan geared towards only accumulation fails to account for protection and their actual income needs in retirement, which we believe is creating this surge of interest in protected income solutions like annuities.”
If the above makes you want to jump on the annuity bandwagon, then here’s an introductory guide to fixed annuities.
What is a Fixed Annuity?
In general, there are three types of annuities:
- Fixed. Payment of a fixed amount based on agreed-upon interest rates.
- Indexed. Annuitants (the contract holders) can be credited for a stock index’s return by the insurer, such as the S&P 500 Composite Index of Stock Prices.
- Variable. This is a tax-deferred annuity contract where you can invest your money in sub-accounts. However, that means the annuitant (the contract holder) is exposed to market risk. This is similar to 401(k)s and the investment options and risk levels associated with them.
If you’re a homeowner, then you’re well aware of a fixed-rate mortgage. For those who aren’t aware of this, it simply refers to an interest rate that doesn’t change over time. An example would be a homeowner who takes out a 30-year mortgage at 3.9% interest and owes principal and interest in accordance with that constant amount.
Fixed annuities operate similarly. The difference is that instead of a debt to the holder, they act as an investment and asset, with the beneficiary receiving a fixed, set amount in return for their contributions. Continuing the mortgage example above, if one owned an annuity paying 3.9% interest, they would receive that income.
How Do Fixed Annuities Work?
When you buy a fixed annuity, you can either purchase it with one big payment or through a series of smaller installments. These are known as premiums. In addition, the company guarantees that the account will earn a certain amount of interest after the annuity has been purchased.
But, how can the insurance company make such a promise? After all, that sounds like a scam, right?
Premiums are typically invested in high-quality, fixed-income investments like bonds by the insurance company. Because the insurance company guarantees your rate of return, the company bears all investment risks. Also, annuities grow tax-deferred, meaning you don’t have to worry about taxes until you begin receiving payments.
“During the build-up phase, interest in a fixed annuity compounds three ways: on your principal, on your interest, and on the tax dollars you would normally pay,” explains Tina Haley, a retirement products expert with American International Group.
“This commingled asset base allows the annuity company to select investments that might be unavailable to the retail investors, which is how the insurance company can justify paying returns that are commonly greater than (certificates of deposit, or CDs) or similar ‘safe’ investments,” adds Jeff Boettcher, founder with Bedrock Investment Advisors.
Unlike variable and indexed annuities, fixed annuities do not fluctuate along with equity markets.
“Right now, some fixed annuities make an attractive alternative to both bonds and CDs in a portfolio, due to the principal guarantees and interest rates offered,” says William Stack, a financial advisor at Stack Financial Services.
Are There Different Types of Fixed Annuities?
When shopping for a fixed annuity, you’ll often be presented with two options; fixed immediate annuities or fixed deferred annuities.
Fixed immediate annuities.
The first type you might encounter is a fixed immediate annuity. Essentially, this is a DIY pension.
By transferring a lump sum to an insurance company, an individual receives a dependable income stream right away or within a few months. In this case, the insurance company will pay incremental payments for a specified period of time or even for life.
Because pensions are becoming rarer, products like a fixed immediate annuity may fill in this gap by providing guaranteed income. But, unfortunately, you may not be able to leave it to your heirs if the annuity is designed to pay out only during your lifetime.
Fixed deferred annuities.
You can also get fixed deferred annuities, where you pay money over a period of time. The insurance company guarantees that your principal will be protected and that your money will earn a certain return, which you’ll collect at a future date. For example, with a Due Fixed Annuity, you will get 3% a month on the money you’ve deposited.
As well as their predictability, fixed deferred annuities also offer low investment minimums, which may be attractive to some investors.
A death benefit usually accompanies this type of annuity. In other words, if an annuity owner dies before payouts begin, the beneficiary will receive the current value of the contract.
From there, annuities can be divided into;
- Traditional fixed. A traditional fixed annuity, also known as a guaranteed fixed annuity, accumulates money at a fixed interest rate set at the beginning of your contract.
- Fixed index annuity. Indexes such as the Dow Jones Industrial Average or the S&P 500 are used as the underlying index for fixed index annuities. However, your principal is protected against losses.
- Multi-year guaranteed annuity (MYGA). MYGAs share many similarities with traditional annuities. In reality, the only difference is the guaranteed rate’s length. For an MYGA, the interest rate is guaranteed throughout the duration of the contract. In other words, there’s no chance of your money’s growth rate changing with time if you have insurance.
How Do Fixed Annuity Rates Work?
Fixed annuities are not linked to the stock market or other investments like variable annuities or indexed annuities. Instead, they yield a predictable interest rate.
More specifically, your money is added to the pool of incoming premiums as soon as the insurance company receives it. Those funds are then invested. These are usually in the form of government or high-quality corporate bonds that earn a somewhat higher interest rate than those issued by insurance companies.
A minimum guaranteed rate will often be included in your fixed annuity contract. That means that your fixed annuity is guaranteed not to dip below that rate by your annuity company. In addition, your principal investment is also guaranteed.
Annuities that provide a guaranteed rate for the duration of the contract include multi-year guaranteed annuities. There are also annuities that allow for interest rate adjustments.
A new interest rate, called a renewal rate, is applied upon the expiration of the set time period. Ask your agent or broker to get an idea of the renewal rate. Although the interest rate will adjust over time, it cannot fall below the guaranteed minimum rate that’s written within your contract.
The Pros and Cons of Fixed Annuities
A fixed annuity has many benefits, mainly having the ability to receive consistent and predictable payments for the duration of the contract. Even better, you don’t have to worry about market volatility. And, fixed annuities tend to offer higher rates than CDs.
But let’s take a closer look at what you should consider purchasing a fixed annuity.
- Predictable and guaranteed income. This type of annuity guarantees you a steady income. Additionally, these payments are regular and predictable no matter what happens in the market.
- Easy to calculate your return. You can calculate the return on an immediate annuity using a simple equation. First, take the total amount of your annuity and divide it by the number of months remaining. For example, this would be the expiration date of the contract or your estimated lifespan. From this, you can calculate your monthly income.
- Tax-deferred growth. As with IRAs and 401(k) plans, annuities grow tax-deferred. As a result, interest that you earn every year is not taxed. How does this benefit you? When your gains are not taxed every year, your savings grow faster.
- Principal protection. Unlike most other investments, a fixed annuity is not subject to market risk. MYGAs, for instance, are a good way to store money you will need in the near future because your principal is protected and accumulating at a fixed rate.
- Some liquidity. If you’re over age 59 ½, you can usually access 10% of the annuity’s cash value penalty-free annually.
- Safe and secure. Fixed annuities are often considered one of the safest and most secure investments. Besides not being exposed to market downswing, they’re also heavily regulated by the state insurance departments.
Another perk? Contributions are unlimited, unlike IRAs and 401(k)s. And, if you want to leave a legacy to heirs, you can bypass probate.
The disadvantages of fixed annuities.
Despite these benefits, there are drawbacks to fixed annuities that you should be aware of.
- Fixed annuities are designed to provide retirement savings. As such, the IRS imposes a 10% penalty on gains withdrawn from fixed annuities for account holders under the age of 59 ½.
- Although a fixed annuity has some great benefits, it’s not the most efficient way to generate retirement income. It’s usually used as a form of accumulation. Variable annuities, for example, are better products for converting assets into income.
- The inflation rate may not be kept up by fixed annuities
- During withdrawals and income payouts, ordinary income tax is owed
- Fixed annuities are not insured by the FDIC, although they are backed by highly rated state-regulated insurers.
Fixed vs. Variable: Which Should You Choose
Even though both variable annuities and fixed annuities can offer benefits, as well as drawbacks, there are cases where one might be better suited.
“Fixed annuities are a better choice for someone who has a low tolerance for risk,” David Clausen, a certified financial planner (CFP) and wealth management advisor with Northwestern Mutual, told Forbes. “In today’s low-interest-rate environment, we are seeing people have a difficult time constructing a bond ladder that provides them the income they need without taking on significant credit risk or burning through the principal.”
If you aren’t a conservative investor and have a higher risk tolerance, you might want to pursue a variable annuity.
“Variable annuities can be a viable solution for those who are willing to stay invested in stock-like markets, but need guaranteed income, living benefit or death benefit tied to their annuity to help them achieve their financial goals,” says Brady Kirkpatrick, a CFP with CenterPoint financial Group, Inc. “For example, some variable annuities have a living benefit attached to them where you can still take some income from a minimum benefit if the markets are down significantly, preventing you from withdrawing principal.”
You should, however, consider your own risk tolerance and how you intend to fill in the gaps in your retirement program when choosing between these types of annuities.
“The primary questions to ask when deciding which type of annuity a client should use center on their tolerance for risk and the role that other assets are playing in their plan,” says Clausen. “Often annuities are used to supplement the planning already in place and to fill in gaps in the plan. Identifying those gaps is a great first step.”
Top 10 Questions About Fixed Annuities
1. How are fixed annuity rates set?
Fixed annuity rates are based on specific factors, such as premium amounts, interest rates, annuitants’ ages, life expectancy, and gender, and are set by insurance companies.
2. Is the interest rate guaranteed for the entire guarantee period in the annuity?
Some products have an initial period in which the interest rate is guaranteed, but after that, the rate may change. A guarantee period annuity may offer a higher interest rate for the first year, for example, and a lower rate the following year.
3. Are fixed annuities guaranteed?
The Federal Deposit Insurance Corporation or any other federal agency does not guarantee annuities. States are responsible for regulating and guaranteeing them.
In the end, the insurance company that sells the annuity determines how safe the product is. Although it’s extremely unlikely for an insurance company to go under, it’s important to choose one with an A rating from insurance rating agencies, such as Fitch or A.M. Best.
4. Can you lose money on a fixed annuity?
As long as you don’t withdraw the money early, you won’t lose money in a fixed annuity. In some cases, penalties and fees will apply if a fixed annuity is withdrawn too soon.
5. How does the interest compound?
“Annuity interest compounds annually unless you withdraw it,” notes Kevin Nuss, CEO of Annuity Advantage. “Not taking withdrawals will allow your funds to produce more interest each year of the contract.”
In other words, if you bought a $100,000 annuity that guaranteed a 3.50% interest rate for ten years and withdrawn $3,500 each year in interest, you would have collected $35,000 in interest at the end of 10 years. Alternatively, if you allowed your interest earnings to remain in the annuity and compound every year, your annuity value would have grown to $141,060 at the end of the 10 years, giving you more than $6,000 over what you would have earned by annual withdrawals, he explains.
6. How is the growth of your funds inside the annuity taxed?
Until your annuity is withdrawn, the interest credited to your account will grow tax-free. With the tax-free growth of your money in the account, your funds have the opportunity to compound significantly over time.
7. How long does the fixed annuity pay?
Another advantage of fixed annuities is the length of the annuity. You can choose a straight life payout with consistent payments every month for the remainder of your life or in one lump sum payout.
If you’re married, you can also select a joint-life payout. This includes payments every month for both your and your spouse’s lives.
Regardless, if you’re considering an annuity contract, be sure it does not charge penalties for early withdrawals.
8. What fees and commissions are associated with fixed annuities?
In general, fixed annuities are less expensive than variable annuities. In addition to commissions, carriers may also charge administrative fees, transfer fees, or underwriting fees. As a rule of thumb, always read your contract thoroughly and ask about all commissions and fees upfront.
9. Do fixed annuities allow me to access my money?
You can usually access a portion of your money penalty-free with fixed annuities. Although allowances differ from carrier to carrier, they are typically calculated as 10% of the account balance or cumulative interest.
This option should only be considered if you are at least 59 ½ to avoid the 10% penalty imposed by the IRS.
10. What are the best-fixed rate annuities?
Annuities that guarantee a fixed interest rate are termed multi-year guaranteed annuities. The rate is typically set for a specific number of years, typically three to ten. The best Multi-year guaranteed annuity rates are 3.05 percent for ten years and 2.95 percent for a seven-year or five-year period, as of October 2021.
For a three-year period, the best rate is 2.35 percent, while for a two-year period, the best rate is 2.15 percent. As such, make sure to stay up to date with the latest rates as they change more frequently than you think.
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