With the glory days of corporate pensions in the past, fixed annuities can serve to augment retirement income from other sources such as Social Security payouts and employer-sponsored funds.
A basic fixed annuity is a contract between a person and a provider — such as an insurance company, independent broker or bank — that guarantees the principal invested, a minimum interest rate and set payouts for the life of the annuitant.
An annuity contract can be for varying lengths of time, such as one, five or 10 years, with a payout phase starting sooner or later depending on whether the annuity is immediate or deferred. (This type of fixed annuity, an income stream that is the focus of this guide, is different from fixed indexed annuities, which can also offer principal protection but credit interest based on the fluctuations of an equity index such as the S&P 500. Check out our thorough discussion of fixed and variable annuities, immediate annuities, deferred annuities and other types here.)
“Simply put, with an annuity product, you are entering into a contract with an insurance company to create your own pension,” says Arvind Ven, CEO of Capital V Group. If you’re interested in the guaranteed income provided by a fixed annuity, here are a few points to keep in mind:
— How fixed annuities work.
— How fixed annuities differ from variable annuities.
— Risks of fixed annuities.
How Fixed Annuities Work
Fixed annuity providers invest your premiums in high-quality, fixed-income investments like bonds. Because your rate of return is guaranteed, the insurance company bears all of the investment risk. Fixed annuities grow tax-deferred.
“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,” says Tina Haley, a retirement products expert with American International Group.
The insurance company backing the fixed annuity aggregates people’s premiums, essentially pooling the risk the company bears.
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“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,” says Jeff Boettcher, founder with Bedrock Investment Advisors.
Basic fixed annuities don’t fluctuate along with equity markets, and they can be simpler to understand than variable or indexed annuities.
“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, financial advisor at Stack Financial Services.
How Are Fixed Annuities Different Than Variable Ones?
Chris Blunt, CEO at Fidelity & Guaranty Life, says annuities get a bad name because of variable annuities, which he says are expensive and basically a mutual fund in an annuity wrapper.
Fixed annuities are classified as insurance products, while variable annuities are both insurance and securities products. That’s because with a variable annuity your premiums are allocated to an investment portfolio.
[See: 7 Types of Fixed-Income Investments.]
While there is potentially more upside with variable annuities, they don’t guarantee a certain rate of return or the principal. In addition to the risk of losing value because of negative performance of the investment portfolio, variable annuities also tend to have higher costs than fixed annuities.
When the stock market declines or gains only a little, “variable annuities will almost certainly underperform the market due to these higher internal fees,” Boettcher says.
Risks of Fixed Annuities
“Fixed annuities are not for every investor,” Boettcher says. “Even when the product fits the client’s needs perfectly, the client will almost always want to maintain assets in other types of investments, like CDs, bonds or stocks.”
A downside to fixed annuities is that they are much less liquid than stocks, bonds or funds — and investors can face penalties such as a surrender charge for early withdrawals.
There can be missed opportunity costs to consider. “While safe and predictable, fixed annuities do not deliver as high of a return as many other types of annuities,” says Eric Henderson, president of Nationwide Financial’s annuity business.
[READ: How to Invest in Bond Ladder ETFs.]
There is also the risk that inflation could start rising faster than forecast and eclipse the payout rate of fixed annuities. “If inflation is greater than the interest credited, the purchasing power of the money in a fixed annuity would be reduced,” says Paula Nelson, an annuities expert with Global Atlantic Financial Group.
It’s important to note that even though the principal for a fixed annuity is guaranteed by the annuity provider, you could still lose a portion of your investment if the company goes bankrupt. States do have guaranty associations to cover insurance company annuity obligations, but that coverage only goes up to a state-determined limit. Investors can check company ratings with AM Best, Moody’s, Fitch Ratings and Standard & Poor’s.
“There is very little risk of loss with a fixed annuity, unless you need to withdraw your funds early,” Stack says.
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Fixed Annuities Guide: How to Use Fixed Annuities for Retirement Savings originally appeared on usnews.com
