What Is Fixed Annuity And How Does It Work?

Financial institutions and employers can provide you with a number of excellent plans to help you save money for retirement. You might already be set up with your own individual retirement account (IRA), an employer sponsored 401(k), a pension, or all three.

Another popular investment for retirement-minded individuals is the fixed annuity. An annuity is a contract you make with an insurance or financial services company in which you exchange regular contributions now for guaranteed future income payments when you retire.

What Is A Fixed Annuity?

A fixed annuity is a type of self-funded investment that provides a guaranteed set amount of payments over a certain amount of time. Fixed annuities are commonly used as retirement income.

A fixed annuity is, in essence, a pension you set up for yourself. Many people like them because, unlike other retirement accounts that are subject to changing market conditions, annuities provide a predictable income stream for their retirement. This helps them set and stay within a monthly budget.

How A Fixed Annuity Works

Once your annuity is set up, you make payments to fund your account like any other retirement plan. In some ways, an annuity resembles other low-risk investments like high-interest savings accounts or certificates of deposit (CD). Payment can be a lump sum or made monthly over a designated period of time.

While in the annuity account, funds grow at the interest rate set by the contract. Every fixed annuity has a current interest rate and a minimum guaranteed interest rate.

When it’s time to start collecting on your annuity, payments arrive every month, like a paycheck. During the payout period, the amount of each income payment to you is generally set when the payments start and will not change. Annuity income payments may be guaranteed for a set period of time or until the end of your life, the life of your spouse or another beneficiary.

The company that holds your annuity makes money from various fees and charges. The Percentage of Premium charge, also known as a “load,” is deducted from each payment before any interest is added. There will likely also be a contract fee that may be a one-time payment or charged annually. There may be a Market Value Adjustment (MVA) provision in your contract that raises or lowers your payments depending on fluctuations in interest rates. Be sure to read the fine print in your annuity contract to understand all charges.

Fixed Annuity Rates

During the period when you are contributing to your fixed annuity, also called the accumulation phase, the fund grows at the current market rate. However, the rate will never fall below the minimum rate of interest set by the contract with your insurance company. The earned interest in your account grows tax-deferred during the accumulation phase – more on that later.

Types Of Annuities

A fixed annuity is the simplest and most straightforward type of annuity, but there are other classes of annuities and each insurance company has different variations.

• Variable annuities: Like a fixed annuity, a variable annuity is an investment account that may grow on a tax-deferred basis and includes insurance features, such as provisions to pay your beneficiary if you die before collecting on the account. You purchase a variable annuity contract with either a single payment or a series of payments. Unlike a fixed annuity, which guarantees a minimum rate of return, a variable annuity offers you a range of investment options, typically in mutual funds that invest in stocks and bonds. How much the fund earns depends on the performance of the investments. Because this type of investment is tied to market performance, it will always carry the risk that you may lose money.
• Indexed annuities: While an indexed annuity is similar to a variable annuity in that it earns or loses money based on market performance, it differs in that its growth potential is tied to returns on a linked market index, such as the S&P 500^® Index. Because it provides protection against negative returns of the same linked market index, the indexed annuity is sometimes known as a buffer annuity.

What Are The Benefits Of Fixed Annuities?

Assuming you invest with a stable insurance company on solid financial footing, a fixed annuity offers a low-risk way to put money away for your retirement. Here are some of the key benefits of fixed annuities.

Tax-Deferred

One of the key features of an annuity is its tax-deferred growth potential. As your investment in a fixed rate annuity grows at the current market rate—or its guaranteed rate, whichever is higher — during the accumulation phase, those gains are not taxed. As the account grows in value, future interest gains are even higher, and so on until you begin to draw income from the account. Remember, though, that when you withdraw those gains they are taxed as ordinary income in the year that they are withdrawn and not as capital gains.

Fixed Interest Rates

While funds placed in a fixed annuity can grow at current market rates, typically in the range of 2% - 6%, they can never fail to earn less than the minimum — or “fixed” — rate guaranteed in the contract. While market tied annuities can earn more, sometimes lots more, if they are wisely invested, fixed annuities offer the peace of mind of guaranteed growth.

Guaranteed Income

Especially if you are less than 40, your retirement planning should include solid, regular contributions to an IRA and/or a 401(k) that invests wisely in market accounts. Investing in securities is historically one of the best ways to grow your money long-term. While a fixed annuity is not invested in the market and only guarantees a small rate of return, that is money you can count on being available when you retire. This makes planning a retirement budget easier and more predictable.

Low Risk

Because it is guaranteed to pay a return — even if it’s at the minimum rate — a fixed annuity is one of the lowest risk places to keep your money. Other investments that can enhance your portfolio’s risk tolerance include certificates of deposit, money markets, treasury bills and savings accounts.

Who Should Consider A Fixed Annuity?

Those looking for a lower-risk investment vehicle should consider a fixed annuity at any point in their lives. They are also attractive to retired people or those near retirement. It’s a great way to stash their money, earn a little interest, and know that it will all be there when they need it. The predictable returns make it ideal for creating a retirement budget.

Fixed Annuity Pros And Cons

The Bottom Line

Fixed annuities are widely available, low-risk investments offered by insurance companies and financial institutions. They are convenient instruments particularly for retiring investors looking to harbor excess cash in an interest-bearing account that will provide guaranteed income when they need it.

No matter how you plan to invest for retirement, the user-friendly Rocket Money^SM app helps you automate the monthly savings you’ll need to start building for the future.