What Are Fixed Annuities And How Do They Work?

The insurance provider guarantees your investment and a minimum interest rate in exchange for your payment of a regular revenue stream. Investors can purchase fixed annuities with either a single payment or a series of payments over time. The insurer sets the initial rate, its term, and a guaranteed rate, which is the lowest that will be paid on the contract. After the initial term ends, the rate is adjusted on a regular schedule. As a result, there’s no way to be sure what the new or current rate will be, though the guaranteed rate remains fixed.

The insurance company determines the payments when the annuity owner or annuitant chooses to start receiving regular income from the annuity depending on the amount of money in the account, the owner’s age, how long the payments are to continue, and other considerations. Your money in the annuity grows tax-deferred until you’re ready to withdraw. The earnings rate paid on your savings, the amount you save, and the length of time your annuity grows all determine the income you’ll receive during the payout period.

What are the types of fixed annuities?

Fixed annuities can be divided into three main categories: traditional, index, and multi-year guaranteed. Guarantee fixed annuities, another name for traditional fixed annuities, build up money based on a fixed interest rate decided upon at the start of your contract.

Fixed index annuities earn interest at a rate determined in part by the performance of a specific stock market index, often the SP 500, not including dividends. If the index gains value during the particular period set in the contract, your indexed account is credited with a return that’s linked to that gain. This provides an opportunity for your account value to grow. If, on the other hand, the index loses value in the specified period, as it may do, your indexed account is credited with 0% interest rather than a negative return.

Another kind of fixed annuity is a multi-year guaranteed annuity or MYGA. Traditional fixed annuities and MYGAs share many similarities. The only notable variation is the length of the guaranteed rate. The interest rate for a MYGA is guaranteed for the duration of the contract period. Therefore, there is no chance that the insurance provider will alter how quickly your money increases over time.

How are fixed annuity rates set?

The company that issues the annuity sets the current rate of interest it will pay on its contract with you and revises it periodically. Rates may be adjusted monthly, annually, or less frequently. When the rate changes, it sometimes increases and sometimes decreases, reflecting what’s happening in the economy. But it can never go below the guaranteed rate, the state-mandated minimum that’s set when you buy the annuity.

Generally, the new rate is based on the return the company is earning on its investment portfolio, typically government and corporate bonds and residential mortgages. The spread, or difference between what the issuing company expects to earn and what it commits itself to pay out, can help offset some of its expenses and provide some of its profits.

The fact that renewal interest rates tend to be lower than introductory, or first-year rates, can complicate your comparison. One solution is to evaluate the performance of older policies and the terms of the new ones offered by the same insurance companies.

The more competitive the annuity market is, the greater the likelihood that the interest rates on the plans you’re considering will be attractive. Typically, the rates are on a par with what you’d earn on a long-term bond and higher than what CDs and money market funds are paying.

What is a bailout clause?

Fixed annuities can have a bailout clause, sometimes known as an escape clause. It lets you surrender your policy without penalty if the offered interest rate drops below a certain level, often one percentage point less than the previous rate, even if it’s above the guaranteed rate. There are a couple of catches, though: Usually, if an annuity’s rate drops significantly, interest rates, in general, have dropped. That means newly issued annuities will likely be paying at comparable levels to the one you’re giving up.

And if you transfer your money to a different type of investment or keep the cash, and you’re younger than 591 ⁄2, you may have to pay a 10% premature withdrawal penalty on your taxable earnings, plus whatever taxes are due. If you withdraw only part of the accumulated contract value, the federal government’s rules say that you withdraw earnings first, not the principal. That means you could pay tax on the entire withdrawal amount.

How do companies invest?

The amount you invest in buying a fixed annuity contract goes into the provider’s general account, along with premiums from other investors and other company revenues. Because the company has such large sums to invest, it can diversify its holdings and earn a better return than you could invest on your own, taking the same investment risk.

A potential downside to buying a fixed annuity may occur if the issuing company gets into financial difficulties since its creditors have a right to assets in the general account. However, these situations are relatively rare since insurance companies are regulated and rated regularly, but they can happen.

Be alert: Companies touting fixed annuity returns much higher than the rates offered by the competition may be too good to be true. Sometimes, promises of stellar returns are a red flag that annuity money is going into riskier investments, like junk bonds. So before buying, ask to see the rate that the issuing company has paid over the past ten years, and be sure to check the company’s ratings.

What are the benefits of a fixed annuity?

Fixed annuities, sometimes called guaranteed annuities, are considered safe because you can count on receiving the specific return you’re promised each year. The guarantee is backed by the insurance company issuing the annuity, not the government. But if you buy your contract from a highly rated company, its financial strength and reputation stand behind it. Rating services such as Standard&Poor’s, Moody’s, A.M. Best, and Fitch rank annuity providers on their overall financial condition, which underlies their ability to meet their obligations.

After the contract’s initial guarantee period has passed, the insurer may change the rate per a predetermined formula or the yield being made on its investment portfolio.

A fixed annuity is a tax-qualified investment, which means that returns grow and compound tax-deferred; owners are only taxed when they remove funds from the account, either through uncommon withdrawals or as regular income.

Fixed annuity contracts often contain a minimum rate guarantee as a defense against falling interest rates. The security of the funds invested in the annuity and the fulfillment of all contract obligations fall under the purview of the life insurance company. Additionally, they offer main protection against market volatility, which is crucial for investors approaching or in retirement.

What are the disadvantages of fixed annuities?

Although fixed annuities have some benefits, they also have some drawbacks. One of the biggest disadvantages is that they frequently carry significant surrender fees if you need to access your money before the maturity date. Therefore, before committing, everyone considering an annuity should know all the costs. Additionally, it pays to compare prices because different insurers may charge quite different fees and other terms.

After you sign up, the annuity company will only promise your fixed, minimal return rate for a predetermined period of years. They will continue to pay you interest after that time has passed, but depending on the conditions of your contract, the renewal rate may be lower than when you initially signed up for.

When you convert your account value to income, the amount you receive is fixed when the payout period begins. It does not increase with inflation the way that Social Security payments do. The significant risk of any fixed income source is that your costs will increase over time, but the income you receive will not. If inflation should grow rapidly, as it sometimes does, an income that was once adequate may leave you short of cash. And the longer you live and continue to collect, the less far your income is likely to stretch, even if inflation increases only modestly.

What Are Fixed Annuities And How Do They Work? by Inna Rosputnia

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