How Do Annuities Work? Your Fixed Annuities Guide
The fixed annuity is an investment contract between an annuitant (investor) and an insurance company. The insurance company agrees to pay the annuitant a fixed income for a period of time based upon the value invested in the annuity. For this reason fixed annuities are also referred to as fixed income annuities.
There are numerous types of fixed annuities, ranging from payments for a set period of time to payments that are dependent on the life span of an individual. The type of the fixed annuity depends entirely on the structure needed for the individual investor.
Fixed annuities are often misunderstood by investors, and as a result carry a certain degree of uncertainty. Many people ask themselves: how do annuities work? In order to successfully and prudently invest in annuities one must form in their mind at least a general understanding of how exactly do annuities work. As with other investments, it is important to fully educate yourself regarding annuities before making a decision. It is important to seek the advice of qualified professionals regarding any investment. Individual circumstance warrant different investment approaches. On this site you will find specific articles intended to give an unbiased description of the fixed annuity, and to provide information on the various aspects of this useful financial product.
What Are The Different Types of Fixed Annuities?
Unfortunately one cannot simply ask: how do annuities work? Because the answer really depends on the different types of fixed annuities you are interested in (on this website we opt to ignore variable annuities and focus on fixed annuities, hence the site name). Despite the many different types of fixed income annuities, fixed annuities will always fall under one of two categories: deferred or immediate.
This concept is pretty straightforward. For an immediate annuity, the first payment from the insurance company is due one payment interval from the date of purchase. If the payment will be paid out monthly, then payments start one month after purchase of the contract. Yearly payouts begin one year after first payment. A deferred annuity requires the fixed annuity to be purchased over a period longer than just one payment.
Other types of fixed annuities include: annuity certain, life annuity, joint annuity, joint and survivor annuity, life annuity certain, and an equity-indexed annuity among others. The differences between these types of fixed annuities are found in the duration of payouts, the designated life on the contract, payment certainty, and bonus stipulations. You’ll find some good information on each of these different fixed annuity types in the information center post: What Are the Different Types of Fixed Annuities?
What are the Advantages of a Fixed Annuity?
One of the most appealing aspects of a fixed annuity is that it pays a fixed dollar amount for the duration of the investment. This can be a particularly appealing feature in times of market volatility (something pretty common these days). The fixed annuity behaves similar to a CD, and provides a guaranteed payment for the duration of the payout period.
Some types of fixed annuities, such as the equity-indexed annuity, will actually pay a minimum interest rate in market downturns, and then provide a bonus during the market’s up years. This can be a very effective way to protect the principal of your investment, and still participate in market upswings. The stipulation with this type of annuity is that it is subject to caps and/ or participation rates. This more or less just means that you only “participate” in a portion of the market growth, or that the growth is “capped.” See the information center for articles on What is an Annuity Cap and What Does the Participation Rate Mean.
Another appealing attribute of fixed income annuities is the ability to provide income for the duration of an individual's life. A life annuity gives retirees a fixed income that they will not outlive. This can be a powerful tool to provide additional security during retirement.
See article on the advantages of a fixed annuity for more information.
What are the Disadvantages of Fixed Annuities?
As with any investment, there are both pros and cons to the financial vehicle. This is very much the case with fixed annuities. While the fixed annuity can provide a definite and recurring stream of income, it can also come with steep penalties if you change your mind. Most annuity contracts have sharp surrender penalties if you attempt to get your money out faster than the predetermined rate. This also makes the investment rather illiquid.
Another weakness of many fixed annuity products is that they generally do not adjust for inflation well. A fixed life income will gradually lose its purchasing power over time. Not all fixed annuity products have this problem, and simply understanding that this can happen can allow you to implement strategies to combat this problem. Many weaknesses of financial products can be overcome with comprehensive financial planning.
See article on the disadvantages of fixed annuities for more information.
Fixed Annuity Summary
The fixed annuity can be a very useful financial planning tool, particularly in retirement planning. Individuals looking for a steady and guaranteed income will find the fixed annuity to be particularly effective. As with all investment vehicles, it is very important to understand the facts before placing your financial future in jeopardy. Be sure to find a financial advisor that you trust and that has your best interest at heart. Fixed annuities are not for everyone. Investment in fixed income annuities should only be undertaken after careful consideration.
For more information on fixed annuities, be sure to explore the rest of the website. The information center is full of detailed information that on key terms and topics that you will be faced with when considering a fixed annuity purchase. They aim to answer the question: How Do Annuities Work? If you find a topic that hasn't been addressed, you are welcome to send us topic suggestions.
The Fixed Deferred Annuity Details
The fixed deferred annuity is the second type of fixed annuity contract that you will come in contact with. As we stated earlier, the annuities will either be immediate or deferred. There is really no other option. If you are looking for immediate payments based off of a one-time premium, then the immediate fixed annuity is probably your best options. Most of the time however, your fixed annuity contract will be a fixed deferred annuity.
The primary distinction that needs to be made with this sort of contract is the deferred portion. A deferred fixed annuity is simply an annuity contract that defers distributions to the beneficiary until a date into the future. This delay can help to facilitate additional growth or savings in the account, preserve capital until it is needed, or delay distributions until the owner reaches a certain retirement age.
The most common period in which to defer payments on this type of deferred annuity contract is until the individual reaches age 59 ½. Payments are generally scheduled to be made over the period of accumulation, and will continue to build interest inside of the account. Most contracts will offer some form of guaranteed growth rate, though this is most common on fixed rate annuity.
Either way, the guaranteed distributions will begin upon the date determined at the start of the contract date. The annuity owner determines what date the insurance company will begin making distributions at the creation of the contract, and agrees to make the necessary premium payments before that date. The actual distribution out of the account will depend on the nature of the account somewhat, and may include some form of additional bonus payments onto the fixed portion of the account.
Fixed deferred annuity contract can be an excellent retirement planning tool if used correctly. They can facilitate tax-deferred growth during the accumulations phase of the account, and delay distributions until they are needed by the retiree. A tiered annuity plan can be established to ensure the investor with continued payments for the duration of their retirement years.
Annuity Riders - What are the Different Types?
While this list is certainly not exhaustive, we have compiled a number or annuities riders that you may come across when shopping for fixed annuities. Each company will have different riders available with their product, and will have variations in how those riders behave. Be sure to explore with your advisor the different options that you can pursue to make sure that you get the best product for your money.
Annuity riders are typically used to establish additional features to the base annuity product. They are the "options" that come with your vehicle; the added extras that make it everything that you want it to be. As such, various riders will not suit everyone. They are designed for specific circumstances.
Let's have a look at some of the common annuity riders:
1. Long-Term Care Rider – Many companies will offer a long-term care rider to attach to contracts. This rider is designed to help ease the strain of unforeseen events. The rider will typically have a feature that will allow for waived or lessened withdrawal charges in the event that the owner is confined to a nursing home or other long-term care facility. These are generally only needed if the event happens within the first year of the contract. Look for contract specifics to determine the length of time necessary to qualify for long-term care rider.
2. Terminal Illness Rider – After the first contract year, if you are diagnosed by a doctor with a terminal illness, you will typically have the option of withdrawing a percentage of the available account value without occurring early withdrawal charges. The percentage allowed to be taken without charge will vary from company to company and product to product.
3. Joint and Survivor – Though this isn't always considered an annuity rider, the joint and survivor option allows the payments from the annuity to continue after the death of the first payee through the life of the second.
4. Joint and Half Survivor – Similar to a joint and survivor option, the joint and half survivor allows the payments to continue after the death of the first payee. The only difference is that after the first death, the payments are then cut in half to the second payee. This assumes that with the first person gone, the payee will only need half the income they needed prior to the first's death.
5. Life Expectancy Guaranteed Income – This is an option that allows you take an income over the course of your calculated life expectancy. Often if you die before this period, your beneficiary will continue to receive the remaining payments. Be careful however, some companies do not mention that if you outlive your life expectancy, the payments will run out.
6. Annuity Death Benefit Rider – This ensures that if you die before the payment period begins; the contract beneficiary will receive the greater of the account value or cumulative premiums paid into the account.
7. Many, many more...
There is a seemingly endless supply of riders and options that can be added to a fixed annuity contract. The important thing to remember is that you are customizing your annuity to how you would like it to behave. Different companies are going to have different options. You also need to be aware of what products are available in your particular state. Some features are restricted to specific states (both company restrictions and state restrictions).
Also remember that as with adding features to a new car, adding riders and options to your fixed annuity contract will also add additional costs. Annuity riders can help you customize your annuity product to your expectations.
Immediate Fixed Annuity Explained
Many people are interested in the fixed annuity product referred to as an immediate fixed annuity. This product can be one of the simplest and most straightforward of fixed annuities contracts.
An immediate fixed annuity is simply an annuity in which a lump-sum payment is made to the insurance company, at which point "immediate" and "fixed" payments commence. The fixed portion of this annuity type is that once payments begin, they pay out a fixed amount each period (month, year, etc. as defined by the contract).]
The payments on an immediate fixed annuity will begin one payment interval after the contract is established. If the contract provides for monthly payments, payments will begin one month after contract commencement. An annual payment contract will make the first payment one year after the date of purchase.
The fixed portion of the contract refers the contract making payments of a fixed dollar amount over a specified period of time or throughout the lifetime of one or more persons. Once these payments begin, they cannot be changed or altered. You have signed up for a fixed payment schedule.
Explore additional areas of this website for more information on immediate fixed annuities and how to integrate them with annuity riders, determine contract details, and other important issues you need to be concerned about.
The Disadvantages of Fixed Annuities
While there are many advantages to fixed annuities, there are also many disadvantages. As with anything, it is a matter of weighing the good attributes with the bad ones.
Let's take a look at some of the disadvantages of fixed income annuities.
1. Poor inflation and hyperinflation protection. Fixed annuities contracts generally do not do well keeping up with inflation. Each year, the purchasing power from the annuities income payments will decrease. Some contracts will have a COLA rider or other inflation provisions built into the contract. Be sure to factor inflation into any fixed annuity income calculation.
2. Annuity can greatly vary from company to company. Because each company puts out their own fixed annuity products, it can be difficult to "shop around" for a fixed annuity. Not all annuities are created equal. This can require the help of an experience professional to determine if a particular product is best for you. By this same token, a professional that has exposure to multiple insurance companies, rather than a company specific agent, will have the ability to help you select the most competitive contracts.
3. Fixed annuity contracts can be complicated. As you can see from some of the articles on this website, the details of a fixed annuity contract can make a big difference as to how the investment actually functions. Minor details make a big difference. (Though this is classified as a con, most financial products these days have this problem. We are living in an increasingly more complicated tax and legal environment).
4. Lower returns on your investment. Fixed annuities, similar to CDs, are meant to provide safety and not great return on investment. If explosive growth is your goal, a riskier investment would be a more suitable alternative.
5. Relatively Illiquid. Fixed annuities are designed to be distributed over a determined number of payments. As such, there are fees and penalties associated with early or unordinary withdrawals from the investment. Many people are hesitant to tie up a large portion of their assets in such an inflexible investment. Keep in mind that this is in the eye of the holder. Whenever you use product differently than it is designed, you are going to have adverse consequences.
6. Income is taxed as ordinary income. While the tax-deferred attributes of fixed annuities is beneficial to growth, once payments begin, income is taxed as ordinary income and not considered capital gains.
7. Surrender charges. As discussed above, there are relatively expensive charges if you decide to cancel your account and pull your money out prematurely.
The disadvantages of fixed annuities should be carefully assessed and considered before any annuity purchase.
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