WHAT IS A FIXED ANNUITY?
A fixed annuity is a type of insurance contract backed by an insurance company who provides a fixed interest rate on the account owner’s contributions. These financial products are particularly favored by those who prioritize predictability and safety in their retirement plans. Unlike variable annuities, where returns fluctuate based on market performance, fixed annuities offer a consistent return, making them a reliable component of retirement planning.
POTENTIAL BENEFITS OF FIXED ANNUITIES
1. Stable Returns
Investing in a fixed annuity can offer several potential benefits for individuals seeking a stable and secure financial future. One of the primary advantages is the guaranteed income stream it provides, which could secure a predictable source of funds during retirement. Fixed annuities typically offer a fixed interest rate, which can protect your investment from market volatility and provide a reliable return. Fixed annuities are not directly tied to market performance, so they provide a stable and predictable income. This can help protect your investment from market downturns, which can be especially important in the years when you are no longer working and relying on your savings.
2. Tax-Deferred Growth
Fixed annuities offer tax-deferred growth, meaning that the interest earned on the investment is not subject to taxes until the funds are withdrawn. This allows the investment to grow without being reduced by taxes each year, potentially enhancing the overall return. This tax-deferred status applies to both fixed and variable annuities, providing a key advantage over taxable investment accounts. However, it is important to note that when you do start making withdrawals, the earnings will be taxed as ordinary income.
3. Payout Options & Longevity Protection
Fixed annuities offer the option to set a payout period, which is a predetermined payment schedule made to the annuity owner over a specified duration. This flexibility serves as a potential benefit by allowing owners to customize their income stream according to their unique financial needs and retirement goals. Common payout schedules include lifetime payouts, fixed period payouts (10 years, 15 years, 20 years, etc.), and joint and survivor payouts for both the lifetime of the owner and the lifetime of their surviving spouse.
For those concerned about outliving their savings, the lifetime payout option can offer longevity protection, providing guaranteed income for as long as you live. This means that even if you exhaust the initial principal and interest earnings, the annuity will continue to make payments, ensuring a steady stream of income in your later years. Knowing that you have a reliable income source regardless of how long you live offers peace of mind. This can be particularly important for retirees who are concerned about the financial implications of increased life expectancy.
These customizable payout options provide flexibility and financial stability, helping individuals align their annuity income with their retirement plans and needs.
POTENTIAL DRAWBACKS OF FIXED ANNUITIES
1. Inflation Risk
Fixed annuities often fail to keep pace with inflation, which can significantly diminish the purchasing power of the annuity payments over time. Since these contracts typically lock in a fixed rate of return, they do not adjust the payout amounts to reflect increases in the cost of living. This could lead to a scenario where, despite receiving regular income, the actual value of the money received decreases as general prices rise. For example, if an annuity pays a fixed $3,000 per month, and inflation rises by 10%, the real value of these payments could effectively drop to $2,700, reducing the annuitant’s ability to cover expenses adequately. While some annuities offer the option to purchase cost-of-living adjustments, these riders are often costly and may not fully compensate for actual inflation rates.
2. Limited Liquidity
Fixed annuities are generally considered long-term, illiquid investments, primarily due to surrender charges and withdrawal restrictions imposed during the contract’s surrender period. These financial products typically limit free withdrawals to about 10% of the annuity’s value per year, complicating access to funds in emergencies. For instance, if an annuitant needs to withdraw a significant amount of money unexpectedly, they might face surrender charges as high as 15% in the first year, which can decrease over time but still represent a substantial financial penalty. Even after the surrender period, most annuities only allow limited free withdrawals, ranging from 5% to 20% of the contract value annually. This structure makes it challenging for annuity holders to respond flexibly to unforeseen financial needs without incurring significant costs or penalties.
Moreover, while some annuities offer provisions for penalty-free withdrawals in specific circumstances such as severe health issues, these options are limited and vary significantly between contracts. This aspect of fixed annuities necessitates careful planning and consideration by potential investors, particularly those who may require more accessible assets.
3. Fees and Charges
Fixed annuities may come with various fees, including administrative fees, mortality and expense risk charges, and surrender charges. These fees can reduce the overall return on your investment. See our article dedicated to comparing annuity fee structures HERE.
4. Lower Returns
Compared to other investment options, fixed annuities typically offer lower returns. While they provide guaranteed income, the interest rates may be lower than what you could potentially earn with other investment vehicles, such as stocks, mutual funds, or structured products. To learn more about structured products, watch our animated video HERE.
5. Tax Treatment
While the earnings in a fixed annuity grow tax-deferred, withdrawals are subject to ordinary income tax rates. Additionally, if you withdraw funds before age 59½, you may incur a 10% early withdrawal penalty.
6. Complexity
Annuities can be complex financial products with various features and options. Understanding all the terms and conditions, as well as how they fit into your overall financial plan, can be challenging without professional guidance.
7. Potential for Reduced Benefits
Insurance companies that issue fixed annuities follow a prudent investment approach by directing the premiums they collect towards high-quality, fixed-income securities. This investment strategy is carefully implemented to ensure that annuity owners receive a consistent and reliable stream of income, even in the face of stock market volatility. By focusing on fixed-income securities, insurance companies aim to minimize the potential impact of market fluctuations on the annuity’s performance.
However, in certain situations, insurance companies may also choose to diversify their investment portfolio by including other asset classes. This diversification strategy is particularly relevant in a low-interest-rate environment, where additional investments can help enhance overall returns. Some insurance companies will invest in more risky investments to provide higher yields on their annuity products to entice investors. When an insurance company invests in high-yield or risky bonds, it exposes itself and the investor to a higher level of risk. If the bonds default, the insurance company may not be able to meet its obligations to annuity holders. This could result in a reduction in the annuity payments or, in extreme cases, the complete loss of the annuity. It is important for annuity holders to consider the financial worthiness of the insurance company issuing the annuity. One way to evaluate the creditworthiness of a company is to examine its financial statements, payment history, industry position, management expertise, and debt levels. Credit ratings agencies also assess a company’s creditworthiness based on a range of factors and provide a rating that reflects the level of risk associated with extending credit to that company.
8. Opportunity Cost
Money invested in a fixed annuity is not available for other potentially higher-yielding investments and opportunities that may come along. This opportunity cost should be weighed against the security and guarantees that a fixed annuity provides.
NO OBLIGATION INITIAL CONSULTATION
Before purchasing a fixed annuity, it is crucial to carefully consider all these potential benefits and drawbacks. Consult with a financial advisor to determine if a fixed annuity aligns with your overall financial goals, perspective on risk, and needs.
At TruWealth Advisors, we are committed to helping you navigate the intricate world of annuities and retirement planning. Our team of skilled financial advisors can work with you to understand your risk tolerance and develop a personalized financial plan. Whether you are considering purchasing an annuity or simply interested in a second opinion, we are here to help. Contact us today for a no obligation initial consultation to explore options that best align with your personal financial goals.
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Additional Resources:
- Fee-Based vs. Commission Based Annuities: A Comprehensive Guide. https://www.twadvisor.com/articles/fee-based-vs-commission-based-annuities-a-comprehensive-guide/.
Disclosures
TruWealth Advisors, LLC is an SEC registered investment adviser located in Louisiana. Registration does not imply a certain level of skill or training. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or financial advice. You should consult your own tax, legal and financial professionals before engaging in any transaction. Past performance does not guarantee future results. Additional information about TruWealth Advisors, including our registration status, fees, and services is available on the SEC’s website at https://adviserinfo.sec.gov/firm/summary/306876.