A fixed annuity is one popular way to secure an income for retirement, with the main advantage being that the annuity guarantees you a certain amount of income. While some fixed annuities may pay income for the remainder of your life, others may pay out only over a certain period.
Here’s what you need to know about fixed annuities, their drawbacks and who should consider buying them.
How a fixed annuity works
A fixed annuity is only one type of annuity, so it’s important to understand first what an annuity is.
An annuity is a contract, typically with an insurance company, that promises to pay a certain income over a period of time in exchange for money upfront. The annuity will pay out over some amount of time, say 20 years, or until the death of the client, depending on how the annuity is structured.
The appeal of the annuity is the relative safety of the income. The annuity may promise a guaranteed return on invested money or a minimum payout value. It may also offer other features such as a death benefit that functions like life insurance on the death of the client.
What makes an annuity a fixed annuity is how the payouts are structured. In this case, a fixed annuity promises a fixed monthly payout on the account, offering a certain income for clients.
With a fixed annuity, clients can contribute money over their working lives or in one lump sum. They may take payments immediately, as in an immediate payment annuity, or they may take their payments later, as part of a deferred annuity.
There are still other kinds of annuities such as variable annuities and indexed annuities, both of which offer other pros and cons.
The potential risks and returns on all kinds of annuities can vary, so clients should understand exactly the kind of annuity they’re purchasing and how it’s structured.
The advantages of a fixed annuity
A fixed annuity shares many of the same benefits with annuities as a whole, but it also offers benefits that are specific to fixed annuities. These advantages include:
- Tax-deferred gains – Like all annuities, a fixed annuity can allow you to build wealth in a tax-deferred account. Earnings are not taxed until they’re withdrawn from the annuity, and if you contribute with after-tax money, then any contributions to the account also come out without any taxes.
- Unlimited contributions – Annuities also allow you to contribute an unlimited amount of money, which can be a significant advantage for higher-income households, allowing them to maximize their tax-deferred growth. Annuities are not limited to the comparatively modest annual maximum contribution limit of a traditional 401(k) or traditional IRA, both of which offer similar tax-deferral benefits.
- Range of benefits – Annuities can also be structured so that they offer all kinds of insurance-like benefits. These include death benefits, survivor’s benefits, guaranteed minimum payouts and other provisions to meet the needs of the buyer. They’re all factored into the price of the annuity.
- Secure monthly income – Besides these pros, a fixed annuity offers the certainty of a monthly income over a specific timeframe, potentially until death. The guaranteed income means that retirees can breathe a bit easier when they’re unable to work.
“As life expectancies increase, it is increasingly appealing to have income that will last for as long as you live,” says Chad Hamilton, CFP, director of practice management at Brown and Company.
Who should consider a fixed annuity?
Annuities can offer benefits, but they’re not for everyone, and prospective buyers should carefully consider the pros and cons of a fixed annuity.
Fixed annuities can make a good choice for those looking for a guaranteed income in retirement, especially if they believe they may live a long life due to family history, are healthy and need the safety of income, says Hamilton.
“Also, if you don’t have a monthly pension or any other monthly income source, it could be a good way to provide an amount of income that is not dependent on the markets or interest rates,” says Hamilton.
By matching a sizable fixed annuity with Social Security — which offers regular but growing payouts — retirees may be able to ensure they’ll have a stable base of income to live from. Of course, they’ll need to carefully plan based on what income they can expect from Social Security.
Still, you’ll probably want to avoid putting all your investment dollars in a fixed annuity, because of the need for growth in your portfolio, especially if you expect to have a lengthy retirement. By maintaining at least some assets in a diversified stock portfolio, you’ll probably have a better chance at growth in later years, helping you to protect your purchasing power.
What are the drawbacks of a fixed annuity?
Despite some advantages of a fixed annuity, it also presents a number of drawbacks to investors, including:
- Complexity – Annuity contracts can be dozens of pages long, with lots of important details written in legalese, making it difficult to understand.
- High fees – Fees can be stacked on to your contract, such as sales commissions, which can run into the high single digits, percentage-wise. You may also be hit with other annual fees. Check your contract carefully.
- Illiquid – Once you sign an annuity contract, it can be difficult or even impossible to get your money out again. You may have to cough up a surrender fee to wiggle out.
- Penalties for early withdrawal – Take out your money from the annuity contract before age 59 1/2 and you could be hit with early withdrawal penalties, lose the tax-deferral benefits of the annuity and even be hit with taxes on your gains.
- Exposure to inflation – A fixed annuity guarantees you a certain income stream, but if inflation rises substantially, then that money may buy a lot less than you’d hoped in 10, 15 or even 20 years. Plus, any money left at the end of the annuity will be worth less, too.
“We all know that the prices of most things are much higher than they were a couple decades ago,” says Hamilton. “The downside of a fixed amount of income is that it cannot keep up with inflation and, therefore, you’ll want to make sure you have other investments with growth potential to complement this type of annuity.”
Hamilton points out another drawback: money paid in an annuity is no longer part of your estate.
“For example, if you invest $250,000 into a fixed immediate annuity, that $250,000 is no longer available as an asset that you can pass on to your heirs,” he says. “It has been converted to an income stream that will (usually) end when you pass away. The exception is if there is a ‘period certain’ type of income benefit, which guarantees that the income will be paid out for a minimum number of years or has a joint life benefit that pays income to a spouse that outlives you.”
Because of the many clauses and benefits that can be inserted in an annuity, it’s critically important that you understand what rights and responsibilities you have under the contract.
Hamilton also says to be sure to select a strong insurance carrier. “The income guarantees offered with these types of products are only as good as the health of the underlying insurance companies,” he says.
Fixed annuities remain a popular type of annuity, because of the relative certainty and security of the income they can provide late in life. However, like all annuities, fixed annuities do come with some important drawbacks, so you must consider whether they meet your needs or not.
Featured image by Marc Romanelli of Getty Images.