A fixed annuity is a financial contract with an insurance company, usually intended to provide a steady income during retirement. It offers a fixed rate of return guaranteed by the issuer over a specified time. Since the guarantee comes from the issuer, it’s important to choose a company that’s highly rated by the major rating agencies, such as Moody’s or Standard & Poor’s.
The rate your money earns may be adjusted periodically at the discretion of the issuing company and by the terms of your contract. But, there is a guaranteed minimum below which your rate will not fall. For example, a fixed annuity may offer a guaranteed rate (say, 3% for four years). If at the end of that period interest rates go up, you may receive a higher rate of interest. But if they go down, and the minimum rate in your contract is 1.5%, your rate will be adjusted down (but not below 1.5%).
Watch Out for Bonus Rates
Some annuities offer a "bonus" upfront. However, this generally just means that you are getting paid some future interest early on. So you may be giving up future interest for the so-called bonus. Be sure you understand how the bonus feature works. Don't get locked into a high-fee fixed annuity simply because of the bonus feature.
A fixed annuity can offer some attractive benefits:
- Lifetime income. You can choose from a variety of pay-out options, including some that guarantee an income for the rest of your life, or your life and your spouse’s (or another beneficiary’s).
- Tax-deferred growth. The earnings in your annuity grow tax-deferred until you begin withdrawals.* However, it is important to understand that, if you hold a fixed annuity inside a tax-deferred 403(b) account, you receive no additional tax benefit.
How Insurers Make Money on Fixed Annuities
With fixed annuities there may be surrender charges if you sell the annuity within a certain time period, often six or seven years. Finally, the insurer makes money on the spread. The insurer takes the money you put into the fixed annuity and invests it (perhaps in bonds) at one rate, and you are paid another. This difference is called the spread. So, for example, if the insurer can make 6% on the money you have invested in the fixed annuity and pay you 4%, they earn 2% each year on the money you've invested.
It’s important to realize that the benefits you receive with an annuity come at a price. Annuities typically have higher fees than other retirement-savings vehicles, often including a mortality and expense charge, surrender charge for early withdrawal, administrative fee and an investment management fee.
In addition, the return on a fixed annuity is generally low, so it may not keep pace with inflation. If you have 10 or more years until you retire, consider whether a fixed annuity is too conservative for you.
Finally learn about the fees you may pay when investing in an annuity.
* Account earnings will be taxed as ordinary income at withdrawal. In addition, withdrawals made prior to age 59½ may be subject to a 10% tax penalty. Premature withdrawals may also be subject to surrender charges by the issuing company.