A Fixed annuity is the most predictable type of annuity. It’s the go-to choice for people who are scared of losing their money on volatile investments. Depending on the terms of your contract, a fixed annuity can provide you with guaranteed income for the rest of your life or for a specified period.
If you are thinking of getting a fixed annuity, here is an article that explains what it is, how it works, and how it differs from other types of annuity.
What is a Fixed Annuity?
A fixed annuity is a type of insurance contract that guarantees you a specific rate of return on your contributions for a set period of time. The interest rate for a fixed-income annuity is usually predetermined by the insurance company and isn’t affected by market fluctuations.
Contributing to a fixed annuity can provide you with a consistent and reliable stream of income for the rest of your life or for a specific time period as determined by the terms of your annuity contract.
How Does a Fixed Annuity Work?
In return for contributing to a fixed annuity, the insurance company guarantees your principal and a minimum interest rate. The minimum rate might not be the current interest rate, but it is the lowest amount of interest the annuity can earn.
Fixed annuities provide protection from the volatility of financial markets and can offer income for life to contributors. You can contribute to a fixed annuity by either paying a lump sum or by making several payments over a time period. A fixed annuity is a tax-deferred savings vehicle so, you do not have to pay taxes until you receive your earnings. Depending on your contract, annuity payments can be received immediately or they can be deferred to a later date.
Deferred Annuity
A deferred annuity delays income payments until a later date, typically at least one year after the annuity contract is issued. Deferred annuities comprise two phases ⸺ the accumulation phase (the period when income is left to build up) and the annuitization phase (payout phase). During the accumulation phase, your principal earns interest and builds value.
Immediate Annuity
An immediate annuity is an annuity contract that is funded by a single lump sum deposit. This is why it is also called a single premium immediate annuity (SPIA). An immediate annuity can make payments almost immediately or within a year of purchase.
Immediate annuities are annuitized at the time of purchase, so they do not have an accumulation stage.
Types of Fixed Annuity
Fixed-income annuities are divided into two categories ⸺ traditional fixed annuities, and multi-year guaranteed annuities.
Traditional Fixed Annuity
Traditional fixed annuities are sometimes referred to as single-year guarantee fixed annuities. In a traditional fixed annuity, an interest rate is set by the insurance company at the beginning of the contract and is reviewed yearly or after a specified period.
Traditional fixed annuities always provide a minimum guaranteed interest rate. Reviewed interest rates may be higher than the guaranteed rate but can never fall below the contractually guaranteed minimum rate.
Multi-Year Guaranteed Annuity (MYGA)
A multi-year guaranteed annuity or MYGA is a type of fixed annuity that offers a guaranteed fixed interest rate for a specified period, usually between 3-10 years.
The major difference between MYGA and traditional fixed annuity is the length of the guaranteed interest rate. With traditional fixed annuities, the rate may be reviewed after a specified period. But with MYGA, the rate can last for the entire contracted term.
How Is a Fixed-Income Annuity Different From Other Annuities?
Like other types of annuity, the aim of a fixed annuity is to provide a guaranteed stream of income to contributors. However, its mode of operation is different from that of other annuity types.
Fixed Annuity vs. Variable Annuity
Contributions to a variable annuity are invested in financial assets like stocks and bonds. So, returns are dependent on market gains and losses. Here are some differences between a fixed annuity and a variable annuity.
- Risk level: The insurer invests contributions to a variable annuity in an array of sub-accounts (mutual funds) selected by the contributor. So, the performance of the investments in your portfolio determines the value of your annuity. This means that if the investments perform well, your annuity value will increase and if they decline, your annuity value will reduce as well. A fixed annuity contract guarantees you your principal and a minimum interest rate. This is why many financial professionals regard fixed annuity as the safest type of annuity.
- Interest rate: The interest rate for a fixed annuity is stated on the annuity contract. If your insurance contract requires a rate review after a specific period, the conditions for re-setting the rate are also stated in the contract. However, with a variable annuity, the interest rate is determined by the performance of the investments in your portfolio. So, interest rates can rise and fall in line with market fluctuations.
- Annuity returns: With a variable annuity, your principal and interest rates are not guaranteed. Instead, returns are dependent on the performance of the investments in your portfolio. The volatility of the stock market and other financial assets means that the returns of a variable annuity can be unpredictable. A fixed annuity offers predictable returns. Unlike variable annuities, you are not at risk of losing your annuity to financial fluctuations. However, not investing in assets means that you might not be able to increase your annuity value.
- Guaranteed minimum interest rate: A fixed annuity contract provides a minimum guaranteed interest rate while a variable annuity does not.
Fixed Annuity vs. Indexed Annuity
Indexed annuities are also known as fixed-index annuities. An indexed annuity possesses the features of both fixed annuities and variable annuities. It is a type of annuity contract that ties interest rates to the performance of a stock market index, like the S&P 500.
Here are some differences between fixed and indexed annuities.
Interest rate: A fixed annuity contract provides a fixed interest rate for a specified time period whereas fixed indexed annuity rates are determined by the performance of the underlying index.
Risk level: Both fixed annuity and indexed annuity guarantee your principal. The key distinguishing factor between the two annuity forms is how much interest the annuity builds over time. The interest rate of a fixed-index annuity rises and falls in line with the market index, whereas the rate in a fixed annuity contract is predetermined and doesn’t change for the specified period.
Annuity returns: Fixed income annuity guarantees your principal and a fixed interest rate for the specified period. So, you might be able to predict how much your returns grow over time. A Fixed indexed annuity also guarantees your principal, but depending on the market index, your interest rate can either grow or decline over time.
Guaranteed minimum interest rate: Both fixed annuity and fixed varied annuity offer a guaranteed minimum interest rate.
Pros of a Fixed-Income Annuity
- Lower risk: A fixed annuity contract guarantees your principal and a minimum interest rate. The returns of a fixed-income annuity are not dependent on the performance of stocks or other financial assets. As fixed annuities aren’t affected by market fluctuations, they can provide contributors with a reliable income stream. Therefore, a fixed annuity contract can be a great option for conservative contributors who do not wish to bear the risks associated with market ups and downs.
- Guaranteed minimum interest rate: Every fixed annuity contract has a fixed interest rate and a minimum interest rate. The fixed rate is set when you sign the annuity contract and typically lasts for a specified period. Depending on the terms of your contract, your annuity provider can set a new rate at the end of the initial guarantee period. The guaranteed minimum interest rate can protect contributors from declining interest rates.
- Predictability: A fixed annuity contract is pretty simple and straightforward. Your principal is guaranteed and the contract states how much interest you should expect to earn. So you do not have to worry about how the market is performing. The predictability of a fixed-income annuity can make it easier to plan for retirement.
Cons of a Fixed-Income Annuity
- Inflation risk: Returns are fixed, so if inflation rises over time, it can cause the value of your contributions to decline.
- Limited earning potential: The risk protection offered by a fixed annuity contract means that you will also not benefit from market gains.
- Penalty for early withdrawals: Annuities are relatively illiquid, meaning that they cannot be easily converted to cash without a loss in value. So, if you withdraw money from your fixed annuity before you are scheduled to, you might incur a penalty charge.
Fixed Annuity and Cost-of-Living Adjustments (COLA)
Over time, inflation can cause the value of the income from a fixed annuity to decline. To limit the effect inflation has on your contributions, you can purchase a cost-of-living adjustment rider (COLA). A COLA rider adjusts your annuity income yearly to match increases in the cost of living.