Guest Author - Reshma Vyas
A fixed annuity can be defined as a contract between an insurance company and an individual. It is generally bought for the purpose of securing retirement income. An individual, (defined as the annuitant) can buy the fixed annuity in a lump-sum payment or through a series of periodic payments. The payment is referred to as the premium. Fixed annuities may appeal to conservative investors who wish to avoid the wide gyrations of the stock market and are interested in securing a guaranteed income stream for retirement.
Types of Fixed Annuities
For nonqualified annuities, the contributions are made with after-tax dollars. They may be a “feasible” option for individuals who have “maxed” out on other qualified plans such as an IRA or 401(k). Fixed annuities can be deferred and immediate. An immediate annuity enables an individual to convert a lump-sum premium into a guaranteed stream of income. A deferred annuity works similarly to an IRA. The earnings grow tax-deferred. The income payments or withdrawals are taxed as ordinary income. The time period during which the annuitant makes premium payments and the annuity account builds up value (the premiums and earned interest accumulate) is referred to as the accumulation phase. When the annuitant elects to receive payments, the annuity is said to have become “annuitized.” This is generally referred to as the annuitization phase or pay-out phase. The payment options are flexible and can be structured so that they can provide income for life or for a specified time period.
Buying A Fixed Annuity
A fixed annuity can be bought through a bank, brokerage firm, credit union or a mutual fund company. The world of annuities is rife with fraud and misinformation. Annuities are a contentious topic among those in the financial services field. Many financial advisors believe annuities to be more or less a fancy marketing gimmick and that for many individual investors, mutual funds (preferably no-load!) may be a far more appropriate alternative.
Pertinent notes about fixed annuities:
• A fixed annuity is first and foremost an insurance product and secondarily a savings vehicle.
• Fixed annuities are not FDIC insured. Insolvency of an insurance company can be a real possibility. One should carefully review their state’s guaranty fund (National Organization Of Life & Health Insurance Guaranty Association, nolhga.com).
• The payout of the annuity is based on the value of the account and actuarial tables. The insurance company takes the risk that an annuitant could outlive their life expectancy and collect payments for a longer period of time.
• The interest rates on fixed annuities are typically low (generally 2 to 3% or slightly more in some cases) in comparison to other types of investments. While the principal and earnings of a fixed annuity are without “risk”, the investment can be vulnerable to inflation. Note that the insurance company guarantees a minimum rate of interest. The guaranteed interest rate is for a specified time horizon (e.g., 3 months to one year), after which it is reassessed and renewed by the insurance company. The rate can fluctuate up or down. The minimum guaranteed interest rate is specified in the contract. Interestingly, some insurance companies may offer an initial “bonus” interest rate which is typically higher than average. The “bonus” rate can be guaranteed for a few months or in some cases, one year, after which the policy may revert to a much lower rate. Cautionary note: all guarantees are dependent on the financial strength and the claims-paying ability of the issuing insurance company.
• Withdrawals are not allowed until age 59 ½. Early withdrawals may be subject to a 10% federal tax penalty and additional applicable taxes. Early withdrawals due to reason of “hardship” may be permitted.
• Every insurance company will differ in terms of its policies regarding fees, interest rates, restrictions and rules. Potential investors should do thorough research rather relying on information presented by the salesperson and the company. It is also essential to evaluate the range of annuity products offered by an insurance company as they will also differ in terms of fees, investment approach, interest rates, limitations and rules. Consider only top-rated, reputable insurance agencies. A few helpful resources include A.M. Best Company Inc., Fitch Ratings, Moody’s Investor Services, Standard & Poor’s and Weiss Ratings. Every ratings service has its own criteria for ranking insurers.
• For nonqualified annuities, there are no contribution limits. There are no mandatory withdrawals.
• May be able to avoid the probate process.
• The beneficiary may receive remaining payments.
• Fixed annuities may contain costly surrender charges (contingent deferred sales charges) and transfer fees.
Fixed annuities appear wonderful when presented in glossy pamphlets and brochures featuring lots of happy, smiling, seemingly contented faces. Before even considering a fixed annuity, one should consult with a knowledgeable retirement specialist or financial planner. The complexity of fixed annuity products may not make them suitable investments for everyone.
For informational purposes and not intended as advice or recommendation. Although every attempt at accuracy and completion is made, the author makes no claim that the content is free of factual errors.