Fixed Annuity

An investment product sold by insurance companies that provides guaranteed periodic (typically monthly) income payments to the annuity purchaser

What is a Fixed Annuity?

A fixed annuity is an investment product sold by insurance companies that provides guaranteed periodic (typically monthly) income payments to the annuity purchaser. It is essentially an investment intended to provide regular income to an individual following their retirement from the workforce.

 

Fixed Annuity

 

Summary

  • A fixed annuity is an investment product sold by insurance companies that provides guaranteed periodic income payments to the annuity purchaser.
  • A fixed annuity offers a guaranteed rate of investment return, much like a bank CD. In contrast, a variable annuity doesn’t offer a guaranteed return but comes with the potential for higher returns than fixed annuities offer.
  • Fees are a major consideration in relation to annuity investments – examine them closely before deciding to invest in an annuity.

 

Understanding Fixed Annuities

A fixed annuity refers to an annuity where the interest rate return that is earned on the money invested in the annuity and subsequently paid out to the annuitant (the purchaser or holder of an annuity) is specified at the time the annuity is purchased.

For example, a fixed annuity might be set at an annual percentage rate of 7%. In such a case, the annuitant is guaranteed to realize a 7% annual return on his annuity investment each year, regardless of how prevailing interest rates in the economy may change over time.

Getting a fixed-rate annuity means that the annuitant will benefit if interest rates decline below their annuity’s fixed rate. Still, they will miss out on potentially higher returns that might have been realized from a rising interest rate environment.

A fixed annuity is thus similar to a regular bank certificate of deposit (CD) that offers investors a specified interest rate over the duration of their investment.

 

Fixed Annuity vs. Variable Annuity

A fixed annuity stands in contrast to the alternative: a variable annuity. With a variable annuity, the income payments that the annuitant receives, rather than being a fixed amount that reflects a constant rate of return, will vary in accordance with how well (or how poorly) the investments that the annuitant selects perform.

Either type of annuity can be purchased with a single, lump-sum payment or gradually invested in over time, just like many other retirement plans.

Annuities typically offer investors a choice of several different mutual fund investments. There is usually enough flexibility in investment options to suit the income desires and risk tolerance levels of just about any investor. If you’re looking to invest in a variable annuity, you should indeed choose your investment(s) carefully, making sure that they are a good match for your personal financial goals and that they don’t exceed your risk tolerance.

Variable annuities provide investors with the opportunity – although there is certainly no guarantee regarding returns on investment – to earn substantially higher profits than what is possible with a fixed annuity. However, with potentially greater reward comes greater risk.

 

Investing Considerations

If your chosen annuity investments fare poorly, declining substantially in value, it will result in a significantly negative effect on the amount of the periodic payouts you receive from the annuity. The key question to ask yourself is whether the income from your annuity will still be enough to meet your post-retirement income needs if, for example, the funds that you invest in decline in value by 5%-10%.

Don’t lose sight of the central fact that the purpose of investing in an annuity is to provide yourself with reliable, regular income during your retirement years. It’s perfectly fine to try to obtain higher returns on your annuity investment, but not at the cost of seriously endangering your standard of living in retirement.

Another factor to consider is the taxation policy on annuities. In the United States, profits from annuity investments are taxed at the annuitant’s regular income tax rate, rather than at the substantially more favorable capital gains rate. It is the basic rule – however, taxation of annuities is also determined by the source (pre-tax or post-tax) of the money you use to fund your annuity. Be sure that you know exactly the tax implications of the specific annuity you intend to buy before deciding to invest.

A final note that’s relevant to both fixed and variable annuities. Beyond the standard management fees and transaction costs associated with mutual fund investments, annuities come with additional investment costs in the form of setup and maintenance fees, and such fees often tend to be on the high side. It’s well worth your while to carefully examine all of the investment fees that are charged with an annuity.

 

Annuity Tips

One of the major advantages that annuities offer investors is exceptional flexibility in investments. Therefore, if, after a thorough investigation, you’ve decided that an annuity fits well with your overall financial plan, you can get very creative in the exact design of your personal annuity investment.

For example, you don’t need to definitively choose between the guaranteed returns that come with a fixed annuity or the potentially higher returns available with a variable annuity. Instead, you may choose to put together an annuity investment that is sort of a hybrid mix of fixed annuities and variable annuities.

Rather than purchasing a single $100,000 annuity, you can opt to purchase two $50,000 annuities, with one annuity being fixed and the other being variable. (You can also vary the amount of money committed to each annuity – it doesn’t need to be a strict 50/50 split – with the same $100,000, you can choose to purchase a $70,000 fixed annuity and a $30,000 variable annuity.)

You can even select a third option – what’s known as a fixed indexed annuity. A fixed index annuity offers a guaranteed minimum rate of return, like a fixed annuity does (although the rate will be lower than what a comparable fixed annuity would provide). It also offers a portion of the higher potential returns available with variable annuities (usually with a cap on maximum percentage return), but with lower risk than a typical variable annuity carries.

 

Keep Learning

CFI is the official provider of the global Certified Banking & Credit Analyst (CBCA)™ Program, designed to teach you all the knowledge and skills required to become a skilled credit analyst. The following CFI resources will be helpful in furthering your financial education and advancing your career:

  • Open-end vs. Closed-end Mutual Funds
  • Personal Finance
  • Fixed-Rate Loans
  • Risk Tolerance

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