Many people have heard of fixed annuities in the world of investing, but most don’t really understand how they work. In simple terms, a fixed annuity is an investment account held with the life insurance company that will one day pay a stream of income. It technically is a type of contract that enables individuals to accumulate capital on a tax-deferred basis. Besides holding tax advantages, a key feature of annuities is that they can provide a stream of income for the entire lifetime of the annuitant, regardless of how long they live. Because of the way annuities work, they are usually used as a form of retirement income for the annuitant.
A fixed annuity is designed to grow over time. In exchange for a lump sum of capital or payments into the annuity, life insurance companies will credit the annuity account with a fixed interest rate all the while guaranteeing the principal investment (meaning the amount invested). A fixed annuity can be annuitized to provide the annuitant with a guaranteed income payout for a specified term or for life. It can even provide for a spouse or other beneficiary for a period after the death of the annuitant. There are lots of payout options. Fixed annuities are a great option when it comes to planning for your financial future.
Fixed Annuities are a form of contract that is issued through a life insurance company to individuals who are either conservative investors or people looking to fix their income during retirement. It provides steady and risk-free returns over a set period of time all for a fee. Since they are technically a form of insurance contract issued through the life insurance company, these contracts reap the same tax benefits of life insurance policies, such as tax-deferred earnings growth. Taxes are paid when the earnings are withdrawn or whenever the contract is annuitized for monthly payments.
How Annuities Work
As stated, the annuity is a contract with the insurance company that basically functions like an investment account that can not go down in value. The cash actually appreciates over time because the insurance company pays a rate of interest on the cash that is invested. The investment account is almost like a bank CD in this way, but when the money is withdrawn there are key advantages to owning an annuity.
Typically, the owner will pay money into the annuity either in one lump sum or in regular installment payments. As the money in the account is growing (before it is annuitized or withdrawals start), this is known as the accumulation phase. On top of the money paid into the account, the insurance company adds value by crediting interest. The interest rate is usually tied to a published rate such as LIBOR. If the owner decides to turn the value of the annuity into a stream of income, this is called annuitization. Once annuitized, the annuity provides periodic payments for some amount of time.
The owner has lots of annuitization options. Each can have advantages and disadvantages to the annuitant (the person receiving the payments). The insurance company can provide periodic payment for a set amount of time, and if the annuitant dies the remaining payments go to a beneficiary. More commonly, people choose to receive payments for life. The insurance company guarantees a fixed payment regardless of how long the annuitant lives. They are willing to take this risk because some people will die younger and the insurance company makes money, and some will die at an older age and the insurance company loses. Over large numbers of people, the insurance company makes money. Life insurance companies are especially adept at predicting how long people in a group will live on average since their entire business model is based upon mortality statistics.
Annuitization options get more complex as well, with options such as life with 10 years minimum guaranteed. If the annuitant dies before the 10 years, a beneficiary gets the remainder until the 10 years of payments are satisfied. If the annuitant outlives the 10-year window, they collect payments until they pass away. Suffice to say, choosing the right option for yourself is very important. It can also be important to your beneficiary, since they may get a payout much like life insurance. A key is to spend a lot of time with your advisor understanding each of your options prior to choosing.
The insurance company will provide an annuity illustration much the same way that they will for life insurance. Different annuitization options can be shown based upon the projected or actual value at annuitization. Each option has a different payout and time period associated with it.
Features Within a Fixed Annuity
The key features within a fixed annuity include the following:
No Losing Money- The principal investment is guaranteed in an annuity. The value is not tied to the stock market or other investment markets, and a minimum interest rate is even guaranteed by the contract. You can not lose money with an annuity unless the insurance company goes bankrupt.
Taxed Deferred Growth – As mentioned previously, fixed annuities offer tax-deferred accumulation of earnings. This directly benefits people in higher tax brackets, which can make a significant difference in the amount that is accumulated over time. When you withdraw the earnings or claim it was income, they then are taxed as ordinary income. The amount of taxes that are paid are determined at that point by the annuitant’s tax bracket.
Guaranteed Minimum Rates – Once the guarantee period expires, the rate is adjusted based on a formula or prevailing yield earned in the insurer’s investment account. As a measure of protection against declining interest rates, fixed annuity contracts include a minimum rate guarantee. Usually, this minimum rate is 2%.
Withdrawals – Fixed annuities typically enable one annual withdrawal per year up to 10% of the account value. During the surrender period, withdrawals that are over 10% are subject to a surrender charge. The surrender charge declines each year until it reaches zero and withdrawals are free from charge.
Guaranteed Income Payments – Fixed annuities may be converted to an immediate annuity at any time to generate a guaranteed income payout for a specified period of time or for the life of the annuitant.
Types of Fixed Annuity
The types of fixed annuities include the following:
Straight Life Annuities – Straight life annuities are the simplest form of life annuities. The insurance component is based on nothing but providing income until death. Once the annuitization phase beings, this annuity pays a set amount per period until the annuitant dies. Straight life annuities offer no form of payout to surviving beneficiaries after the annuitant’s death. If you are seeking to leave an estate to survivors, it is advised to keep other investments if they are inclined to purchase a straight life annuity.
Substandard Health Annuities – Substandard Health Annuities are straight life annuities that could be purchased by someone with critical health problems. These annuities are priced in correlation with the annuitant dying in the near term. Lower the life expectancy, the more likely that the annuity will be expensive. This is because there is a lesser chance that the insurance company will make a return on the money that the annuitant invests. Therefore, the annuitant of a substandard health annuity will also receive a lower percentage of his or her original investment in the annuity.
Life Annuities With a Guaranteed Term – Life annuities with a guaranteed term offer more of an insurance component than straight life annuities through allowing individuals to designate a beneficiary. If the annuitant was to die before the term has passed, then the beneficiary will receive the sum that has not yet been paid out. If there was an earlier than expected death, then annuitants do not forfeit their savings to an insurance company. This advantage will come at an additional cost in the form of lower payouts.
Fixed Annuities are great for saving for retirement and guaranteeing regular streams of income during it. They are often utilized for tax deferral and as a conservative method of savings.
Having said that, annuities are complex. Over a lifetime, they may not provide as high a return as investing in the stock market. In addition, there are many features and options within each annuity. Annuity contracts are complicated and those who are unfamiliar with them may not get back what they intended. In order to reap the benefits of reduced taxes, stable returns, and the invaluable peace of mind that fixed annuities offer, investors need to research instruments against other retirement-income sources such as pension payouts or 401(k)s. It is important to speak with a life insurance agent before making any financial decisions.