A fixed annuity is a contract between an individual and an insurance company. It is designed to provide a guaranteed stream of income over a specific period, typically during retirement. The core appeal of fixed annuities lies in their predictability – they offer a set interest rate and periodic payments, shielding investors from market fluctuations. As a result, the insurance company assumes the majority of the risk associated with a fixed annuity. If you’re considering a fixed annuity or similar product, a financial advisor can help you determine if it’s a good fit for your retirement.
What Is a Fixed Annuity?
A fixed annuity is a type of insurance contract that offers the potential for a steady income throughout retirement and aims to safeguard against market volatility by offering the annuitant a specified interest rate on their contributions for a certain period.
Here’s how it works: An individual makes a lump sum payment or a series of payments to an insurance company. In return, the insurance company pledges to make periodic payments to the annuitant. The annuity can start immediately or be deferred to a later date, allowing the principal to grow over time.
One key advantage of fixed annuities is that they offer a fixed interest rate, providing a predictable income stream. This interest rate is determined by the insurance company and is outlined in the annuity contract.
Insurance Companies Assume the Risk
The insurance company that sells you your fixed annuity assumes the lion’s share of the risk. When you purchase the contract, you’re essentially transferring your risk to the insurer. They promise to pay you a fixed, predetermined interest rate for the duration of the contract, regardless of economic conditions. This means that even if the stock market plummets or interest rates decrease, your income remains stable. This safety net makes fixed annuities an attractive option for risk-averse individuals.
Insurance companies select and manage investments that will yield a sufficient return to cover the promised interest rate and make periodic payments to you, the annuitant. They use reserves and actuarial calculations to predict and cover future liabilities.
If the investments underperform, the insurance company must make up the difference to ensure the agreed-upon payments are made to the annuitant. In essence, they bear the risk of the market’s unpredictability to deliver a steady income to the annuitant.
Pros and Cons of a Fixed Annuity
Fixed annuities offer several advantages. They provide the potential for a steady income, which can bring peace of mind to retirees. They also aim to safeguard the principal, shielding it from market volatility and trying to ensure that the annuitant’s nest egg remains intact.
Furthermore, fixed annuities offer tax deferral on investment income, allowing the annuitant to potentially grow their savings faster. Lastly, they can possibly leave a death benefit to heirs, making them a tool for estate planning.
However, it’s important to understand the drawbacks of fixed annuities. They lack liquidity, as substantial surrender charges may apply for withdrawals within the first few years. In addition, the fixed payments may not keep pace with inflation, potentially eroding the purchasing power over time. These factors must be considered when evaluating whether a fixed annuity is the right retirement income strategy.
Potential Risks for the Annuity Holder
While the insurance company bears most of the risk, annuity holders or annuitants do face some limited risks. For instance, if you decide to withdraw your money from the annuity before the contract’s maturity date, you may incur surrender charges or fees.
Additionally, if the insurance company behind your fixed annuity were to face financial instability or bankruptcy, there could be a risk to your investment. However, these scenarios are relatively rare, as insurance companies are heavily regulated to protect policyholders. Insurance companies must join nonprofit guaranty organizations in the states in which they operate. If a member company goes bankrupt, the other companies in the organization chip in to pay the remaining claims, up to $250,000.
Fixed annuities are also exposed to inflation risk because the purchasing power of their guaranteed payments can erode over the years. For example, if an annuity holder receives $1,000 per month, that amount may not have the same buying power in 20 years as it does today, given the rising cost of living. To address this risk, some annuity holders may choose to include inflation protection riders in their annuity contracts, but these options often come at an additional cost.
Keep in mind that the risks fixed annuity holders face are relatively minor compared with the security offered by these insurance products.
Bottom Line
In the realm of fixed annuities, the distribution of risk is clear. The insurance company assumes the lion’s share of investment risk by guaranteeing fixed payments, regardless of market performance. On the other hand, annuity holders do face some risks, including the potential erosion of their purchasing power over time and the possibility that the insurance company goes under.
Retirement Planning Tips
- Delaying Social Security beyond your full retirement age will boost your eventual benefit by as much as 8% per year until age 70. If you have enough money saved or other sources of income, you may consider the Social Security bridge strategy, whereby you defer your benefits and rely on your other income in the meantime. This allows your eventual benefit to increase and reach its maximum value.
- A financial advisor can help you plan and save for retirement. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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