What Is a Fixed Annuity? Uses in Investing, Pros, and Cons

What Is a Fixed Annuity?

A fixed annuity is a type of insurance contract that promises to pay the buyer a specific, guaranteed interest rate on their contributions to the account. By contrast, a variable annuity pays interest that can fluctuate based on the performance of an investment portfolio chosen by the account's owner.

Fixed annuities are often used in retirement planning.

How a Fixed Annuity Works

Investors can buy a fixed annuity with either a lump sum of money or a series of payments over time. The insurance company, in turn, guarantees that the account will earn a certain rate of interest. This period is known as the accumulation phase.

When the annuity owner, or annuitant, elects to begin receiving regular income from the annuity, the insurance company calculates those payments based on the amount of money in the account, the owner's age, how long the payments are to continue, and other factors. This begins the payout phase. The payout phase may continue for a specified number of years or for the rest of the owner's life. There may also be death benefits.

During the accumulation phase, the account grows tax-deferred. Then the account holder annuitizes the contract. Distributions are taxed based on an exclusion ratio. This is the ratio of the account holder's premium payments to the amount accumulated in the account that is based on gains from the interest earned during the accumulation phase. The premiums paid are excluded and the portion attributable to gains is taxed. This is often expressed as a percentage.

This situation applies to non-qualified annuities, which are those not held in a qualified retirement plan. In the case of a qualified annuity, the entire payment would be subject to taxes.

A fixed annuity can be either an immediate annuity, which starts paying out immediately, or a deferred annuity, which starts paying out at some point in time that is determined by the annuity contract.

Benefits of a Fixed Annuity

Owners of fixed annuities can benefit from these contracts in a variety of ways.

1. Predictable Investment Returns

The rates on fixed annuities are derived from the yield that the life insurance company generates from its investment portfolio, which is invested primarily in high-quality corporate and government bonds. The insurance company is then responsible for paying whatever rate it has promised in the annuity contract. This contrasts with variable annuities, where the annuity owner chooses the underlying investments and assumes much of the investment risk.

2. Guaranteed Minimum Rates

Once the initial guarantee period in the contract expires, the insurer can adjust the rate based on a stated formula or on the yield it is earning on its investment portfolio. As a measure of protection against declining interest rates, fixed annuity contracts typically include a minimum rate guarantee.

3. Tax-Deferred Growth

Because a fixed annuity is a tax-qualified vehicle, its earnings grow and compound tax-deferred. Annuity owners are taxed only when they take money from the account, either through occasional withdrawals or as regular income. This tax deferral can make a significant difference in how the account builds up over time, particularly for people in higher tax brackets. The same is true of qualified retirement accounts, such as Individual Retirement Accounts (IRAs) and 401(k) plans, which also grow tax-deferred.

4. Guaranteed Income Payments

Fixed annuities may be converted into an immediate annuity at any time the owner selects. The annuity will then generate a guaranteed income payout for a specified period of time or for the life of the annuitant. Depending on the contract, the payouts may continue for beneficiaries after the annuitant has died, such as a surviving spouse and/or dependents.

5. Relative Safety of Principal

The life insurance company is responsible for the security of the money invested in the annuity and for fulfilling any promises made in the contract. Unlike most bank accounts, annuities are not federally insured. For that reason, buyers should only consider doing business with life insurance companies that earn high grades for financial strength from the major independent rating agencies.

Fixed Annuities vs. Variable Annuities

Fixed and variable annuities are similar: they are tax-advantaged insurance products that can support retirees with periodic payments. This income in retirement can extend until death, or after it, for an annuitant's beneficiaries. Typically a surviving spouse is selected as the beneficiary of the account, but others are also eligible, including dependents and close friends.

However, there are also differences between the two.

A fixed annuity is based on a guarantee: you will receive a specific payment, regardless of what the markets are doing. During the payout phase, your payments are fixed. That isn't the case with a variable annuity, which is affected by market performance. During the payout phase, your payments will be higher or lower, depending on your investment choices.

A fixed annuity is the more conservative option, as its growth is determined via a fixed interest rate and it ensures a regular, predictable income stream. It may be the right choice for someone with a lower risk tolerance. However, the upside potential is lower than what you might earn with a variable annuity, which is the riskier option. A variable annuity's asset mix, which includes mutual funds, offers more potential for growth than a fixed annuity's fixed interest rate. However, this comes with more volatility. There are also more fees with a variable annuity.

Choosing between a fixed or variable annuity will likely come down to your risk tolerance, and what you want from your retirement.

Criticisms of Fixed Annuities

The main downside for annuities is that you're likely going to pay relatively high fees. Take the surrender charge, in particular: during the annuity's surrender period, which can run for as long as 15 years from the start of the contract, if you withdraw over 10% of the account's value, you will need to pay a hefty fee. Annuity owners who are under age 59½ may also have to pay a 10% tax penalty, in addition to regular income taxes.

Annuities are also relatively illiquid. Fixed annuities typically allow for one withdrawal per year of up to 10% of the account value.

For these reasons, an annuity is appropriate only for long-term investing and as a source of regular income, not for regular spending or even one-time large purchases, such as the downpayment on a second home or to fund gifts for grandchildren. Other vehicles, such as a high-yield savings account (for home purchases), a living trust (for certain gifts after your death), or a 529 plan or a custodial account (for gifts relating to educational expenses) are more appropriate in these circumstances. Annuities are also inappropriate for money that an investor might need for a sudden financial emergency. (An emergency fund will typically be a better option in this situation.)

The Bottom Line

Annuities are complex insurance contracts designed to sustain investors in retirement.

However, they often carry high fees compared to other types of investments. It's wise to make sure you understand all of the fees involved before you commit. It also pays to shop around, because fees and other terms can vary widely from one insurer to the next.

Don't take this decision lightly. Take your time to consider the pros and cons. It's possible that an annuity isn't right for you at all.