The Fixed Annuity - Your Fixed Income Annuity Guide

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.    Annuities 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.

8.    Fees, Commissions, etc. One of the biggest complaints regarding annuities is that they often have quite steep upfront purchase charges.  The sale of the annuity is often associated with a commission on the end of the salesperson.  Fees to create the account also factor into the cost of the annuity.  While these are bulked into the purchase price of the annuity, many are wary of their impact on the product.

The disadvantages of fixed annuities should be carefully assessed and considered before any annuity purchase.

Advantages of the Fixed Annuity

The fixed annuity is an interesting investment vehicle for the conservative investor.  The behavior of a fixed annuity is most often compared to that of a cd.  While there are definately disadvantages to fixed income annuities, they can provide the average investor a number of benefits.  These advantages are generally more favorable for those that wish to hold the investment long term, are looking for safety from market risk, or have already reached or are nearing retirement age.

Let's take a look at some of the advantages of fixed annuities, in no particular order:

1.  Tax deferred growth.  One definate advantage the fixed income annuity has over cds is tax-deferred growth.  Your investment is allowed to accumulate tax-free until distributions begin.  Unlike some of the other insurance products, the distributions from a fixed annuity are not tax-exempt.

2.  Protection of principal.  Unlike other investment vehicles, the principal of the account is protected from downward loss.  Variable annuities, securities, and other investments can lose value.  The fixed annuity has a fixed interest rate, independent of market downturns.

3. Guaranteed Rate of Return.  The fixed annuity contract establishes a predetermined return on your investment.  This provides a reliable and predictable income, providing safety and peace of mind to the investor.

4. Opportunity to annuitize.  Though one of the more obvious features of an annuity, the opportunity to annuitize shouldn't be overlooked.  Distributions can be spread out over a set period or may continue for the life of the annuitant.

5. Creditor Protected (depends).  In some states and depending on the vehicle, the fixed annuity is probate and creditor protected.  In protected states it can also be protected against frivolous lawsuits.  This again provides another level of security to the investment.

6. Annuity income doesn't count toward calculations for social security benefits.  Income from the annuity is not counted against your allowable income to recieve social security benefits.  This can provide an increased retirement income, and lower tax liability.

7. Lifetime payout provisions possible. Worried about outliving your income?  The fixed annuity can be established to provide a guaranteed income for the life of the annuitant.  This again provides safety and peace of mind.

8. Not vulnerable to market volatility.  Can you say recession buster?  Because of the fixed rate nature of the annuity,  the investor need not worry about account values during periods of recession.

9. Inflation protection* (though doesn't bode well with hyperinflation).  COLA and other inflation adjusting provision (sometimes just in the form of the interest rate) can be written into the annuity contract.

*This is admittedly almost a disadvantage.  Fixed annuities have traditionally not managed to keep up with inflation, though improvements have been made in this regard.

While this list is not comprehensive, it should give you a good look at the advantages of fixed annuities.

Owner-driven vs. Annuitant-driven Fixed Annuity Contracts

A very common question is what is the difference between owner-driven and annuitant-driven contracts?  Annuitant-driven contracts are currently more common; however there are becoming more and more owner-driven fixed annuities.  The primary difference is in how the contracts are treated upon the death of either the annuitant or owner.

In an owner-driven fixed annuity contract, the death of the contract owner or joint-owner (however the account is specified) will trigger payout of the death benefit to the designated annuitant.  This can come in the form of a lump sum distribution, an annuitization, life expectancy payments, or spousal continuation.

In an annuitant-driven fixed annuity, the death of the owner triggers the account annuitant receiving the contract value and not the death benefit (though the insurance company may specify otherwise).  The account value could be less than the expected death benefit.  When the contract annuitant dies, the beneficiary will then receive the death benefit associated with the account.

In annuitant-driven accounts, the death of the owner and not the death of the annuitant can trigger both the five-year deferral rule and the spousal continuation.

For example, consider a couple that decides to purchase two separate annuity accounts.  They decided to cross-own the accounts, where the husband owned and was beneficiary of one account with the wife as annuitant, and the wife owned the other account and was beneficiary with the husband as the annuitant. The children were established as contingent beneficiaries.  When the wife dies in this example, the account in which the wife owned and was beneficiary automatically goes to the children as contingent beneficiaries.  Because the husband is no longer associated with the account, a tax liability is suddenly enacted.

In this case, it would have been more beneficial to have the owner changed to the annuitant.  The husband should be owner and annuitant on one account, and the wife owner and annuitant on the other account.  If it is established this way, the couple will be able to elect the spousal continuation.  However, there are circumstances in which this wouldn't apply.  As with any financial product, it is important that read the prospectus of the contract and work with a professional that handles these types of products and problems daily.  Owner-driven and annuitant-driven fixed annuity contracts have subtle and minor differences that can make a huge difference in the outcome of your contract's execution.

What are the Different Types of Fixed Income Annuities?

There are numerous types of fixed income annuities, and while it would be problematic to try and list each and every variation, we have compiled a list of the most common.  Each of these different types of fixed annuities may have numerous strategies associated with them and will vary from company to company.  These types of annuities are also not mutually exclusive.  Some contracts will combine several of the following fixed annuities.

Annuity Certain - this is annuity contract in which the recurring payments are made for a definite period of time and are not dependent upon the lifespan of an individual.

Cash Refund Annuities - this is a type of refund that pays the annuitant's defined beneficiary the difference, if any, of the purchase price of the annuity and the sum of the payouts to the deceased annuitant.

Equity-Indexed Annuities - a type of fixed annuity that has a guaranteed minimum interest rate and also offers a bonus dependent upon an equity index (market conditions).

Installment Refund Annuity - this type of annuity contract promises to continue to provide benefits to a beneficiary if the annuitant dies before recouping the purchase price of the annuity.  The payments will generally continue until the full cost of the annuity has been refunded.

Joint and Survivor Annuity - similar to a joint annuity, this is an agreement in which the fixed annuity covers the life of two or more individuals.  This annuity continues to make payments for as long as any of the covered individuals live.

Joint Annuity - this type of fixed income annuity covers the life of two or more individuals and terminates at the first death of those covered.

Life Annuity - this is an agreement upon which the payments are based upon the life of an individual.  Payments in a lifetime annuity stop upon the death of the designated individual.  This type of fixed income annuity is also referred to as a whole-life annuity or a single-life annuity.

Life Annuity Certain - this type of fixed income annuity provides a determined number of payments regardless of whether the individual lives or dies.  The contract will also continue for the duration of the annuitant's life if they live beyond the predetermined payment period.

Modified Cash Refund Annuity - this type of annuity is a variation on the traditional refund annuity.  When an annuitant dies before receiving the full amount of retirement benefits equal to their contribution, the remainder will be distributed to the annuitant's beneficiary.

Pure Annuities - an agreement that simply provides periodic payments for the duration of an individuals life, and terminates at the individual's death.

Refund Annuity - a refund annuity is any type of annuity that also promises to return a portion or all of the purchase price of the annuity.

Temporary Life Annuities - this is a modified life annuity in which the contract is determined on the life of an individual for a set period of time.  The contract terminates at the earlier of either death or the end of the determined period.

What Does the Participation Rate Mean?

Some types of fixed annuities, most commonly equity-indexed annuities, have a participation rate associated with the contract.  These types of annuities provide bonus income based upon market upswings.  When the market is down, the contract maintains a minimum interest rate.  However, on market upswings, the account is credited according to the growth of the index.  In order to balance out down markets, the insurance company only allocates a portion of the growth to the annuitant.  This portion is called the participation rate.  Participation rates will generally range from 35% up to as much as 100%, though at 100% participation there is generally a cap (see article on a fixed annuity Cap).

Consider an annual point-to-point strategy on an equity-indexed annuity.  This strategy compares the S&P 500 value at the beginning of the year and the end of the year.  If the market increases 10% over this period, a 65% participation rate would credit the annuitant 6.5%.

Remember to discuss participation rates with your financial planner before purchasing a contract.  Not all annuities are created equal.