Traditional annuities earn a fixed rate of interest and pay a fixed income.

When you buy a fixed deferred annuity contract, you get two promises from the issuer: a fixed rate of return during the accumulation, or build-up, period while your retirement savings compound, and many ways to receive retirement income, including payments that are guaranteed to continue for as long as you live.

The two promises are related. 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.

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. There’s no way to be sure what the new, or current, rate will be, though the guaranteed rate remains fixed.

Build up

Setting the rate

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 at large. But it can never go below the guaranteed rate, the state-mandated minimum that’s set when you buy the annuity.

In general, the new rate is based on the return the company is earning on its own 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.

You can comparison shop for earnings potential as well as for high ratings and financial strength of the insurance company providing the annuity. 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 as well as the terms of the new ones offered by the same insurance companies.

Bailout clause

Fixed annuities can have a bailout clause, sometimes known as an escape clause, that lets you surrender your policy without penalty if the interest rate that’s being offered 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 are likely to 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.

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How companies invest

The amount you invest to buy 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 on its investment than you could investing 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. These situations are relatively rare, however, 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. 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.

Pay out

SAFETY FIRST

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 your contract. 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. These reports are available online, from your financial adviser, and from the insurance company if you request them.

Income issue

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 major risk of any fixed income source is that your costs will increase over time, but the income you receive will not. If inflation should increase 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.

While you usually buy a fixed annuity to provide retirement income for yourself, or for yourself and your spouse, you can also purchase an annuity to provide lifetime income for another person whom you support, such as an elderly relative or a disabled child.

Comparative rates

The more competitive the annuity market, 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 Are Fixed Annuities And How Do They Work? by Inna Rosputnia

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