Have you been looking for a way to invest your money with relatively low risk, but with a higher return than the interest rates of CDs offered by banks and credit unions?
Look no further than fixed annuities. For decades, fixed annuities have provided a secure form of savings for millions of conservative investors on a tax-deferred basis. They are by far the simplest type of annuity contract and offer all of the benefits provided by any type of annuity except for the opportunity for market participation.
Let’s look at the details of a fixed annuity and how to decide if it’s the right investment for you.
What Is a Fixed Annuity?
In a fixed annuity, you have the option to make either a lump sum contribution or a series of contributions to the contract, which in turn will pay a guaranteed rate of interest for a set period of time. These instruments resemble CDs in many respects: Both the principal and interest are guaranteed, and you’ll face a penalty for early withdrawal. As with all types of annuity contracts, there is a 10% early withdrawal penalty from the IRS for any distribution you take before you’re 59 1/2 years old.
History of Fixed Annuities
Fixed income annuities are the oldest type of annuity contracts that governments have offered to the public. Caesar sold annuities, requiring a lump sum payment and promising yearly returns for citizens. European governments funded most of the wars of the 17th and 18th centuries with annuity contributions. In the United States, fixed annuities appeared in the 18th century as a way to support church pastors. After a Pennsylvania life insurance company got the commercial ball rolling in 1912, the contracts quickly became popular, and now they’re used by millions of conservative investors.
Basic Terms and Rates for Fixed Annuities
In addition to the benefits of tax deferral, your choice of payment options, and exemption from probate and creditors, fixed annuities usually pay higher rates of interest than CDs or other traditional guaranteed instruments. As a result, savvy investors look to these contracts to achieve a slightly superior rate of growth.
- Fixed annuities usually mature after anywhere from one year to ten years.
- In most cases, they will automatically renew at a revised interest rate unless you withdraw or move the money.
- Rates of return will depend on current interest rates and reset when the annuity matures.
- In some contracts, you’ll get a “teaser rate,” a higher rate that’s only valid for the first year of the contract term.
- In other fixed annuities, you’ll start with a lower rate but watch it rise by a set amount every year until maturity.
As with all other types of annuities, fixed annuities usually contain a schedule of declining surrender charges, usually between 7% and 15% – above and beyond the 10% early distribution penalty levied by the IRS. This charge gradually decreases by a percent or two each year until it is gone.
For example, a 12-year fixed annuity contract may charge a 10% penalty for any funds you take out within a year of purchasing the contract, a 9% penalty for anything withdrawn in the second year, and so on until the surrender charge schedule expires completely. But many contracts let you withdraw anywhere from 10% to 20% of the value of the contract every year with no penalty, providing some liquidity.
Additionally, accumulation units are purchased with all payments that are made into the contract. These units accumulate and grow inside the contract until it is annuitized. Annuitization is a single, one-time event that happens in every annuity contract. The accumulation units are irrevocably converted into annuity units, and the contract starts to make payments in some form to the beneficiary.
Fixed Annuity Payout Options
Beneficiaries have several payout options to choose from, including:
- Straight life. Set dollar amounts – based on actuarial tables – that pay out over the rest of your life, even if the total payments exceed the amount of original contributions plus growth. The downside of this payment option is that the payments will stop at death, even if the total payout is less than the value of your original investment.
- Joint life. An option for you and a co-beneficiary, in which you’ll be paid as long as one of the two of you is living.
- Life with Period Certain. A payout plan that continues for as long as you live or over a set amount of time – like ten or twenty years – preventing the insurance company from keeping the balance if you die before receiving the entire contract value.
- Joint Life with Period Certain. A similar plan that applies the same protection of paying as long as you or your beneficiary are living, or over a set time period.
- Systematic Withdrawal. A set dollar amount or set percentage of the contract value paid out each year.
- Lump Sum. A single payment that liquidates the contribution, letting you either take all of the money in cash or roll it over into another annuity contract.
Taxation of Fixed Annuities
As long as you don’t withdraw your funds before you turn 59.5, the cash you invest in a fixed income annuity contract grows tax-deferred until you start taking distributions. Once you start collecting, the IRS will tax your payments the same way they would any other income – and you’ll see it in Box 3 of Form 1099-R. The tax rate is determined using a formula called the exclusion ratio, which distinguishes taxable income from tax-free income. You’ll get your principal back tax-free, but income and growth are taxable.
If, for example, you invest $200,000 in a fixed contract and it doubles to $400,000 and then you receive monthly payments of $700, the exclusion ratio mandates that 50% (since the principal is now half of the total value) of each payment ($350) will be considered a tax-free return of principal.
How Safe Are Fixed Annuities?
The principal and interest in a fixed contract is backed by the financial strength of the life insurance carrier offering the product. Life insurance companies are rated according to their financial strength and given a grade, such as AAA or AA. Most major carriers have several ratings provided by each of the major rating agencies, such as Moody’s, Fitch, and Standard and Poor’s. Stable carriers obviously receive higher ratings, while smaller, less established companies are assigned lower grades.
But state laws require that all fixed annuity carriers maintain a cash reserve that is at least equivalent to the total value of all outstanding fixed annuity contracts, regardless of what they are rated. This provides a safety net for all fixed annuity holders that can be counted on in times of financial turmoil. Finally, reinsurance companies usually step in and cover customer losses whenever an annuity carrier becomes insolvent. Therefore, although fixed annuities are not FDIC insured, your chances of losing the money in one of these contracts are so low that this possibility can be ignored for all practical purposes.
That’s why older investors and other people with short time horizons often purchase these contracts. Wealthy investors also use fixed annuities to shield a portion of a large portfolio from market risk and taxation. But fixed annuities are probably not the ideal vehicle for those seeking higher returns over longer periods of time.
Because they are guaranteed instruments, fixed annuities can comprise some or all of the safe portion of a retirement portfolio. For example, if you’re a 65-year old investor with a $250,000 retirement portfolio, you could allocate $100,000 of your money in a fixed annuity contract paying 5%, which would guarantee an income of $5,000 per year until the contract matures while preserving the underlying principal. The rest of the money could be allocated among mutual funds or other securities, depending upon your investment risk tolerance and investing objectives.
Fixed annuities provide a safe means of saving for retirement as well as guaranteed income. Conservative investors who look to banks and CDs should seriously consider these contracts as a more competitive alternative to taxable instruments. For more information on fixed annuities, consult your financial advisor or life insurance agent.
What are your thoughts on fixed annuities and how do they compare with other investment vehicles you have in mind?