Annuities are our specialty

Understanding Fixed Annuities

It is not too big of a stretch of the imagination to compare the last twelve years of the stock market to a huge roller coaster ride which is an experience that few people can stomach: Up, down, loop-d-loop, climb and then crash. The really unnerving part is that, when the ride starts up again, it will do exactly the same thing. How fun is that? Not much if that’s your retirement nest egg going for the ride. Meanwhile, fixed annuity owners have been happily floating along on their merry-go-round, grabbing the brass ring with each rotation.

The Importance of Fixed Annuities in Retirement Planning

Fixed annuities have been providing investors with portfolio stability and long term guarantees for decades. Smart investors, especially those with a retirement time horizon, invest in a combination of growth investments like stocks and stable investment like fixed annuities. The result for a retirement portfolio is a much smoother ride and more stable long term returns. Once pre-retirees understand how fixed annuities work, they realize their value to the overall performance of their retirement portfolio.

Key Characteristics of Fix Annuities

There are many ways to add stability to a retirement portfolio. CDs and government bonds can add safety and stability, but only fixed annuities offer a mix of guarantees and flexibility that can ensure the long term stability and security that retirees need. Its unique characteristics of tax advantages, competitive interest rates, minimum rate guarantees, withdrawal provisions, and, ultimately, secure lifetime income, combine to provide investors with a portfolio foundation upon which they can more confidently add some growth oriented investments.

Tax-Deferred Accumulation

If all other aspects of fixed yield alternatives were equal, the tax deferral of earnings inside fixed annuities gives them an edge as a long term accumulation vehicle. Consider two equivalent vehicles, a taxable CD and a fixed annuity, both yielding 4%. For an investor in a 40% combined tax bracket, the after tax return on the CD is actually 2.4%. Over the long term, the difference could amount to thousands of dollars of additional accumulation with a tax deferred fixed annuity. Withdrawals from annuities are taxed as ordinary income, and any withdrawals made prior to age 59 ½ may be subject to a 10% penalty by the IRS.

Competitive Yields

Fixed annuity yields are typically compared with those of bank CDs, yet, historically, fixed annuity yields tend to be higher. The difference can be attributed to the type of financial institutions from which they originate as well as the methods for determining the yields. CDs are time deposits offered through banks. Because bank deposits are used by the bank to loan money, their yields are based on prevailing short term interest rates, which makes them very sensitive to interest rate movements.

Annuities are offered through life insurance companies who invest the deposits with their general account. The general account is invested in a portfolio of short, intermediate and long-term bonds, which, when managed effectively, can generate a higher yield, a portion of which is applied to the annuity accounts.

Minimum Rate Guarantee

The initial yields on fixed annuities are usually guaranteed for a specific period of time, from one to five years, after which they are reset based on a formula or the current interest rate environment. The risk with any fixed yield vehicle is that, if interest rates, in general decline, the possibility exists that the new applied rate will be much lower than the initial rate. Fixed annuities include a minimum rate guarantee which acts a floor below which the new rate cannot drop. As compared with other fixed yield vehicles, this feature offers investors more predictability on the growth of their funds.

Withdrawal Provisions

One of the criticisms of annuities is that they require a long term commitment before investors can access their funds. Setting aside the fact that they are designed as long term retirement vehicles, annuity contracts do include a withdrawal provision that allows investors to take out a portion of their funds each year without charge.

Up to 10% of the accumulated funds can be withdrawn, and amounts in excess of that will be charged a withdrawal fee. The fee, ranges from 7% to 12% in the first year, and then decreases by a point each year, so that, when it declines to zero, there are no more withdrawal fees. Again, withdrawals made prior to age 59 ½ may be subject to a penalty unless certain conditions exist, such as disability or hardship.

Secure Lifetime Income

Annuities originated long ago primarily as income vehicles. In return for a lump sum deposit a life insurance company promises to pay a guaranteed income stream for the life of the annuitant. Fixed annuities were introduced to allow for an accumulation period in which a lump sum can grow over time before it is converted into income.

At the time the income is needed, a fixed annuity can be “annuitized” to generate a monthly income which is fixed for a certain period of time or a lifetime. Once the income begins, the annuity balance is irrevocably retained by the life insurer who guarantees the income, for as long as the annuitant is living. This becomes the income “safety net” that allows investors to continue to assume some risk with the rest of their portfolio in order to achieve higher yields.

How Fixed Annuities Deliver All of That

Annuities are insurance contracts issued by life insurers which, in essence, protect you against the risk of living too long (as opposed to dying too soon with life insurance contracts). So, all of the guarantees and provisions discussed here are bound in the contract which consists of an accumulation phase and a distribution phase. In return for your deposit, the life insurer is obligated to return to you a minimum amount of money, either in the form of accumulated funds, or as a guaranteed monthly income.

Life insurers have been fulfilling this obligation for a couple of centuries without fail. It is the unique structure of life insurance companies that creates the security that annuity owners enjoy. Life insurers are regulated by state insurance commissions who apply very strict investment and financial guidelines that must be followed. Essentially, life insurers are required to maintain a reserve of funds that can always pay all of its future obligations, with interest. And, in most states they must also operate with a capital surplus which ensures the security of its reserve.

As secure as fixed annuities are, investors can add another layer of security by working with life insurers who rank highly based on the strength of their financial condition. Rating agencies, such as A.M. Best and Standard & Poor’s regularly evaluate all life insurers and apply a rating. With dozens of insurers offering competitive annuity products, there’s no reason not to work with the top companies.