Fixed annuities aren't right for every investor. They require a level of commitment that other investments don't. But those who choose a fixed annuity can be guaranteed income for years, decades, or even life. While other retirement income investment options like stock dividends and bond coupons can provide income, none provide guaranteed income regardless of market conditions.
Fixed annuities in particular allow an investor to plan and budget based on the amount of the payment each month. Fixed annuities have risks, so they should be carefully considered. For example, in an environment of rising interest rates, a fixed annuity may not pay enough to offset inflation. Fixed annuities, then, should be considered as one part of an investment portfolio, the income from which supplements other retirement income sources.
Choosing Between Deferred and Immediate Fixed Annuities
Deferred fixed annuities have an accumulation phase and a distribution phase. During the accumulation phase, which can be as long as several years or several decades, the owner of the annuity makes regular deposits with either pre- or after-tax dollars. The deposits are called the premium and they can be either the same amount or they can vary. Like all annuities, deferred fixed annuities grow tax-deferred until payouts begin after retirement.
The distribution phase begins when the owner annuitizes the account by electing to take payouts. He or she can usually choose monthly, quarterly or annual payouts. But once the choice is made, it cannot be changed. Guaranteed payouts can be taken for life or for a set number of years. This choice will affect the amount of each distribution payment.
Deferred fixed annuities are a good choice for income if you're nearing retirement or are already retired and need continued growth but not immediate income. The tax-deferred growth shelters the money you use to purchase the annuity from state and federal taxes. Most life insurance companies also offer very competitive rates on fixed annuities and most companies now also offer a guaranteed death benefit. This is critical, especially for older investors who may fear outliving their assets and outliving a spouse.
Deferred fixed annuities are not at all appropriate if you're in your 20s or 30s. Given the number of years until retirement, tax-deferred growth should be gained from investments that offer a higher rate of return. If you're in your 40s or 50s, a fixed annuity can be a good place to shelter money if you're a doctor, lawyer, or other professional who could be sued.
As the name suggests, an immediate fixed annuity does not have an accumulation phase. Rather, payouts begin within 12 months of purchase. Immediate annuities are funded with one premium, typically with money from a savings or money market account, an insurance policy, an inheritance, or the proceeds from the sale of property or a business. An immediate annuity is a means of prolonging the purchasing power of a nestegg to ensure that it lasts through all of retirement.
Clearly, immediate fixed annuities are only suitable for those who need immediate income. They are best suited to those investors who fear they will outlive their savings. They can also be well-suited to those who feel they cannot manage their money properly in retirement. Once the annuity is purchased, it's the responsibility of the insurance company to earn enough on the investment to make the guaranteed payouts.
Understand the Risks of Fixed Annuities
There are three main risks associated with fixed annuities. The first is inflation and interest rate risk. The second is the financial health of the insurance company. And the third is the death of the annuitant before the premium has been returned in the form of the payouts.
All things being equal, inflation represents the largest risk to any portfolio. Even in a period of low overall inflation, it's possible that volatile items like food and energy will rise faster than the rate of overall inflation. And while most of us might be able to put off buying a new couch or car until interest rates are more suitable, we can't put off buying food or heating our homes. If you purchase a fixed annuity and interest rates rise, you will in effect be losing money. Therefore, it's a good idea to look into a fixed annuity with a cost of living adjustment (COLA) rider. Adding a COLA rider will increase the price of a fixed annuity, but the amount of money that is paid out each year should at least be equal to the rate of inflation.
It can't be stressed enough that the financial health of the life insurance company must be scrutinized. Annuity payouts are only as safe as the credit rating and financial soundness of the company that guarantees them. The four leading credit rating agencies, A.M. Best, Fitch, Moody's Investor Services and Standard and Poor's, issue a rating that indicates the ability of the life insurance company to meet both its current and future financial obligations. While the credit rating alone should not be the only criteria used to choose a company, it does provide information about a company's credit risk and how safe your money will be.
The third risk of fixed annuities is that the annuitant could die before he or she has received back in full the amount that was paid in during the accumulation phase or with the lump sum premium. This risk, however, has lessened over the past several years. Almost all insurance companies now guarantee the premium. In other words, if the annuitant purchases an annuity for $500,000 and dies after having only received $250,000 in distributions, the beneficiary will receive the remaining $250,000. A different option to have the premium returned is known as "period certain". With a 20-year period certain fixed annuity, the beneficiary would receive the balance of the premium if the annuitant dies before the end of the 20 years.
Getting the Best Fixed Annuity
The key to getting the best fixed annuity is to find the highest yielding annuity when interest rates are as high as possible. In general, the longer term, the higher the rate you'll receive. It's always prudent, however, to find the annuity with the right term for your unique financial situation and not focus on interest rate alone.
Think of fixed annuities as preserving assets, not growing them. While they're not FDIC insured like CDs -- which also service to protect assets -- annuities will provide a set amount of income. Don't forget that you'll need to make sure you have adequate cash on hand in other liquid accounts to cover emergencies. An annuity is a contract that cannot be cancelled without penalty. Once purchased, the only reasonable way to get your money back is through the distributions.
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More Annuity Guidance
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- Immediate vs Deferred Annuities — Learn how to choose between annuity types.
- Annuity FAQ — Answers to commonly asked annuity investment questions.