How Does a Fixed Annuity Work?

With the recent stock market volatility, many investors are concerned about losing their retirement income. If you rely on income from your investments, the type of crash we saw following the global financial crisis can be scary. As a result, many are considering annuities. Fixed annuities are getting special attention, since a minimum return is guaranteed, as well as the principal.

Annuities: The Basics

In most cases, insurance companies issue annuities as a contract, promising to make fixed payments to the person who purchases the annuity (the annuitant). The company accepts payment for the annuity, either in a lump sum or in installment payments over a period of years. The insurance company can invest that money to try and grow it, becoming profitable. At a certain point, agreed upon ahead of time, the issuing company begins making regular payments to the annuitant, usually during retirement.

Earnings from annuities are tax deferred. The interest earned is usually added to the annuity balance and the balance continues to grow over time. The annuitant doesn’t pay taxes on the earnings until they are withdrawn from the annuity. If you have an annuity, you receive regular, fixed payments over time after a specific date, guaranteeing you an income in retirement. This stability is one of the reasons that annuities appear so attractive. However, it is important to note that the insurance company guarantees the earnings and the principal, and an annuity is only as strong as the company that issues it.

There are two main types of annuities: Fixed and variable. While there are different hybrid annuities and products, many annuities fall into one of these categories. With a variable annuity, the rate of return varies with market conditions. A fixed annuity has a minimum return guaranteed, and can also earn extra on top of that minimum, if the insurance company feels that market conditions warrant it.

Fixed Annuity Options

Many companies issuing fixed annuities offer a minimum guaranteed rate of return, and then set a flat rate, depending on market conditions for a period of time, such as a year. There are some contracts available, however, that will lock in a higher fixed rate for a multi-year period of time. The idea of getting a fixed rate of return can be tempting, but you will also need to consider whether or not that rate will beat inflation. You may need other investment earnings to help you keep ahead of inflation.

When you purchase a fixed annuity, you can choose immediate fixed annuity, or a fixed deferred annuity. An immediate annuity is purchased, and payments begin almost immediately. It is becoming common for a retiree to withdraw a large chunk of money from his or her retirement account and use it to purchase an immediate annuity with the lump sum. That he or she is guaranteed a set monthly, quarterly or semi-annual payment that can serve as income. It is important, however, to understand the tax implications of this maneuver. Consult with a trusted tax professional before proceeding.

A deferred annuity is purchased by someone who wants to accumulate at a fixed rate before beginning to receive payments. Those who choose this option usually do not have the capital to purchase in a lump sum (although deferred annuities can be purchased with a lump sum), but want to be able to rely on the income at retirement. Many deferred fixed annuities come with installment plans, in which the annuitant pays regular premiums for a specific period of time. Then, when the time comes, it is possible to receive steady retirement income. The main downside to this arrangement is that the guaranteed fixed rate of return can be somewhat low, and you could miss out on more effectively growing your nest egg.

When choosing a fixed annuity, it is important to be aware of fees. Annuities come with fees ranging from load fees to contract and transaction fees. Make sure that you understand the terms of the annuity as well, since you might not be getting what you think you are. It helps to have an independent financial professional look over the annuity before you buy, to help you ensure that a fixed annuity is really the right move for you.