Fixed Annuities: How Does a Fixed Annuity Work?

A fixed annuity is considered to be the simplest and most reliable type of annuity. It is a relatively easy and straightforward way of saving money as compared to other investments. Once a fixed annuity has been purchased, tax-deferred interest starts to accumulate over time and payouts are guaranteed. Since they are averse to market risks and offer steady growth, fixed annuities are often used in retirement planning too.

Here’s a closer look at the basics of fixed annuities and how they work.

What is a fixed annuity?

A fixed annuity is a type of contract between an investor and an insurance company. For a specific time-period, it promises to pay the investor a predetermined, guaranteed rate of interest on the contributions made by them towards the annuity.

Fixed annuities are considered to be great retirement planning tools as they can provide a steady stream of income to retirees. The rate of interest might be low, but it is guaranteed. More importantly, it does not depend on prevailing market conditions, unlike many other investments.

Fixed annuities can be broadly classified into two types based on funding and payout terms:

• Deferred annuity: A deferred annuity, as the name suggests, defers payouts to the investor for a set period. Investors do not start receiving money immediately, and payouts begin at least one year after the annuity has been purchased.

  Typically, a deferred annuity receives contributions from the investor over several years. As such, deferred annuities are great for individuals who are working and can make contributions until they retire. Once retirement sets in, they can finally start receiving payouts for their long-term investment.

• Immediate annuity: Unlike deferred annuities, an immediate annuity starts making payouts to the investor within a year of purchase. In some cases, payouts can begin immediately after the annuity has been purchased.
  Generally, immediate annuities are funded with a singular, lump sum payment. They are a good option for retired individuals who want to start receiving cash payments at once.

How does a fixed annuity work?

Owing to their popularity and demand, fixed annuities are sold by insurance companies, banks, brokers, and many other companies that offer financial services. Once an annuity has been purchased, certain terms have to be agreed upon by the buyer and the seller.

The buyer can choose whether to receive a lump sum amount or spread the payments over a set number of years. This set period of guaranteed payments can differ as per the specific terms of a contract and is commonly known as the ‘guarantee period’. An investor might even continue to receive payments for the remainder of their life if the contract stipulates such a condition. Since fixed annuities do not depend on market fluctuations or other types of investments, the interest rate is also pre-determined.

Once the guarantee period of a fixed annuity ends, investors can decide what they want to do next. They can choose to renew the annuity contract, divert the funds to another type of annuity or transfer the balance into a different type of retirement account altogether. Investors who do not want to pick any of these options can instead turn their balance into a steady stream of income.

The period an investor makes contributions towards a fixed annuity is commonly known as the ‘accumulation phase’ while the period in which they make withdrawals is known as the ‘distribution phase’. Much like a certificate of deposit (CD), investors are generally offered a higher interest rate if they opt for a longer accumulation phase. However, there is a major difference between a CD and a fixed annuity.

When it comes to a CD, the penalty for early withdrawal is relatively small. Typically, 90 days of interest has to be forfeited by an investor who wants to withdraw money before that guarantee period elapses. On the other hand, investors who opt for early withdrawal on their fixed annuity might be required to forfeit as much as 9% of their investment as surrender charges. In addition to this, the Internal Revenue System (IRS) also charges 10% as early withdrawal fees.

The pros and cons of fixed annuities

Although fixed annuities can be a very safe and reliable way of investing money that does not mean that they do not have drawbacks. Here are some pros and cons of fixed annuities:

Pros

1. Simplicity: One of the biggest advantages of fixed annuities is that they are relatively simple to understand. Unlike other types of investments, they do not have any complications when determining the value and recurrence of payouts. Fixed annuities have clear contract terms and do not contain any kind of underlying fees whatsoever. They can be purchased easily too.
2. Assured returns: Since the rate of interest is fixed beforehand, investors can predict how much they will earn in the future and plan for their retirement accordingly. The same cannot be said for other investments where returns are directly linked to market fluctuations and the performance of other investments.
3. Low-risk: Fixed annuities are considered to be low-risk investments as they are not interdependent on other factors and offer a guaranteed payout. This makes them especially appealing to retirees who cannot afford to lose any money.
4. Guaranteed minimum rate: Fixed annuities guarantee a minimum return on investment in the form of payouts. A fixed annuity can be converted into an immediate annuity by the investor at any given point of time. When this is done, the annuity generates regular payouts for a set number of years.
5. Tax benefits: The money that has been invested in a fixed annuity grows tax-deferred until the time of withdrawal.

Cons

1. Lower Returns: Compared to other types of investment options, fixed annuities have a relatively lower rate of interest. Consequently, they generate lower returns. Moreover, since they are not dependent on market conditions, losses are avoided, but gains are not shared either.
2. No protection from inflation: Since interest rates are pre-determined, the growth of these annuities is fixed and does not factor in inflation. Their actual value decreases during periods of high inflation.
3. Early withdrawal penalties: Another downside with fixed annuities is that the early withdrawal penalties can be quite high. Early withdrawals can lead to hefty surrender charges. If any money is withdrawn before the age of 59.5 years, the Internal Revenue Service (IRS) also levies a 10% withdrawal penalty.

To sum it up

Fixed annuities are steady, reliable investments that guarantee fixed returns irrespective of any external factors. They can be perfect for risk-averse investors, especially for those who are nearing retirement. Investors only need to understand how fixed annuities work and whether the benefits that accompany them overshadow their drawbacks.

If you want to know more about fixed annuities, get in touch with a professional Financial Advisor in your city.