Last Updated: January 2021
Fixed annuities have a lot to offer and can be extremely beneficial towards your retirement planning.
While some annuities have more aspects that are less predictable but can offer more potential gain, others are more reliable, predictable, and an investment you can depend on for your retirement years.
A fixed income annuity certainly falls into the class of predictability. It can help seniors create a stream of income during some of the tightest financial years of their life.
The rest of this quick article is designed to break down and make the fixed annuity easy to understand. You’ll learn the pros and cons, plus a more in-depth analysis of this investment option.
Here is what will be covered:
- How Fixed Income Annuities Work
- The Benefits of Fixed Income Annuities
- The Cons of Fixed Income Annuities
- Alternative Investments to a Fixed Annuity
- How Can You Begin Shopping for Fixed Income Annuities?
How Fixed Income Annuities Work
Fixed-income annuities are often purchased by individuals that are more risk-averse and prefer a guaranteed percentage of earnings on their retirement or savings.
Most commonly, fixed annuities are purchased by offering a large lump sum of cash in exchange for a guaranteed interest rate of return on your investment that will be paid periodically that you select when you enter the contract.
Examples can include monthly, quarterly, semi-annually, or annually.
Annuities and the Accumulation Period
After your initial investment, unless you choose an immediate annuity (more on this later), your money will begin what is referred to as the accumulation period.
The accumulation period is nothing more than the time your annuity spends gaining additional principal and compound interest by taking your initial investment and earning your fixed interest rate, which will commonly fall between 2-4% in the current market.
Fixed annuities are considered the most basic and easy-to-understand form of annuity you can purchase. Especially compared to other options such as variable annuities.
Some people ask “are annuities safe?” The fixed income annuity is the safest type of annuity.
The Benefits of Fixed Income Annuities
The pros of fixed annuities are relatively straightforward.
Fixed Income Annuities are Easy to Understand
Investments are not always easy to wrap your head around. Often, it is difficult to understand how our investment will protect us if certain situations arise and what exactly we are benefiting from when investments have complex fees and additional features.
With fixed annuities, it is an entirely different story. Fixed income annuities are very simple investments.
There is no fancy math taking place with a fixed annuity that needs to be completed. You put your lump sum of money you have (most typically a savings or a rollover from an IRA or retirement fund) into the annuity.
In exchange, the life insurance company will offer you a fixed percentage/interest rate for a specific period.
Example of Investing in a Fixed Annuity
Investing in a fixed annuity could look something like this:
- $100,000.00 lump sum money is invested and given to the insurance provider.
- The insurance provider pays you a 3.00% interest on your annuity for 20 years with the withdrawal of $5,000.00 per year or $416 per month.
- This allows you to collect your 3.00% interest while drawing your lump sum of cash monthly to meet expenses.
Note: The above example is not based on any real numbers or current annuity rates. It is in no form an actual payout structure from any specific company.
Fixed Annuities Make You Feel Safe and Are Predictable
One of the most sought after benefits of fixed annuities is that they are safe investments.
- You can’t lose your initial principal.
- They will at least earn some form of interest during the accumulation phase and the payout phase.
- The interest rate you will be earning on a fixed annuity is set in stone before the contract is ever signed and guaranteed.
It is a simple exchange of cash for the ability to monthly stream income while earning interest without dozens of different fees involved.
It is very straightforward, easy to comprehend, and a safe way to guard retirement assets while still earning some extra money during the process.
Risk is Extremely Low with Fixed Annuities
The last significant benefit of choosing a fixed annuity is the peace of mind that comes with it.
Virtually no risk is involved with purchasing a fixed annuity.
The interest rate that you set at the beginning of the contract is not based on anything except the guarantee provided and the contract you enter when purchasing your annuity.
You have no market performance to worry about, which has always been an ideal and recommended way for seniors living on a fixed income to invest.
The Cons of Fixed Income Annuities
With all the benefits we discussed a moment ago, it should also be noted that fixed annuities do not come up without some drawbacks that need to be considered as well. Here is a quick look at those.
Fixed Annuities Can Struggle to Keep Pace with Inflation
Although fixed annuities can easily be deemed safe and like the best approach to retire with peace of mind, you do begin running into an entirely new problem: Inflation.
At 2-4% returns on your annuity, your investment is not going to do well with winning the race against inflation. It is projected that inflation will be 2.27% in 2021, according to Statista.
Clearly, if this is the case, you would have to find an annuity that is paying the best rates available to out-run the ever-rising cost of living.
To get up to speed at options capable of doing this, be sure to read our article breaking down the highest paying fixed annuities here.
Annuities Have Low Upside
Anytime you have something with no risk involved, it is rare that you have a chance at a high reward. This is especially true with fixed annuities.
While you can feel great about knowing that your investment is protected, you also have to live with the fact that you will never see more than that flat interest rate you agreed upon when you initially started your annuity.
It is one rate for the duration of the annuity. Nothing more and nothing less.
Deferred Taxes is Great, Taxed at Ordinary Income Is Not So Great
There is no denying that it is a benefit to be able to defer your earnings until the later years of your investment.
When you do begin pulling your annuity withdrawals and taking your supplement incomes, your earnings will be taxed each year as ordinary income. This is typically a larger tax amount than being taxed on capital gains.
Fixed Annuities have Surrender Fees
A pitfall to always avoid when purchasing any kind of annuity is strapping yourself too tight on funds.
When you invest in an annuity, you cannot access all of that cash if you need it for an emergency without paying a penalty, called a surrender fee.
Work with a reliable and trustworthy financial professional to ensure you have the living capital, emergency funds, and liquidity before purchasing an annuity.
Alternative Investments to a Fixed Annuity
You always have other options you can consider for your retirement planning outside of a fixed annuity.
Sticking within the annuity investing arena, you can also chase more gains and take more risks by choosing a variable annuity.
Variable annuities are known to have higher fees and have more risk of principal loss inside of the investment account but also provide the opportunity to earn a higher percentage than your typical 2-4%.
There will be pros and cons of annuities, no matter which type you choose.
For other options, it is best to speak to a licensed financial professional who can look at your entire portfolio, current needs, and help you plan for a secure and enjoyable retirement.
How Can You Begin Shopping for Fixed Income Annuities?
Annuity rates are frequently changing and are subject to change at any time. The rates are set by insurance companies. This makes it imperative to ensure you are checking the rates frequently and with a large handful of companies to ensure you are locking yourself into the best interest rates possible.
When you begin your search, stick with trusted insurance providers that have strong financial strength ratings and a good track record.
Annuities can serve as a valuable tool for any retirement plan, especially for people seeking decent returns with less risk. With the world rapidly changing, and it is becoming more difficult to plan, fixed annuities are still a great way to earn interest and have some certainty built into our retirement years.