What is a Fixed Annuity and How Does it Work?

Last update on: Aug 17 2020
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By Olivia Faucher

Definition of a Fixed Annuity 

Under a fixed annuity contract, also known as a fixed deferred annuity, the annuity owner makes a deposit with the insurance company and the insurance company guarantees the annuity account will be credited with interest at a specified, guaranteed interest rate.

The interest credited to a fixed annuity account is not tied to any external factors such as the performance of different investment markets. Instead, the interest rates is set, usually before the start of a year and guaranteed for the year. In most fixed annuities, the interest rate is reset each year based on the insurance company’s expected investment return and expenses for the coming year. The investor has peace of mind that both the principal is protected and the income for the year is predictable.

Both the principal investment and the interest credit are guaranteed, making fixed annuities a low-risk investment. The following example demonstrates how a fixed annuity works:

William is a 48-year-old saving for retirement. He wants a portion of his nest egg invested so that the principal is safe and a reasonable interest rate is earned. He deposits $125,000 with an insurance company in return for a deferred fixed annuity. The insurance company guarantees the principal deposit will be safe and that 3% will be credited to the account. At the end of the first year, William’s annuity account balance is $128,750, an increase of $3,750, or 3% of his initial deposit. Before the start of the second year, the insurance company announces the interest credit earned during the coming year will be 2.5%. At the end of the second year, William’s account value is $131,969. The account earned $3,219 during the second year.

This continues each year until William decides he wants to receive income from the annuity. Most annuities offer several options for taking distributions. William can withdraw the entire account value as a lump sum. He also can take periodic distributions and has several choices of periodic distributions. The periodic distribution options are explained more detail below. 

 

How Does a Fixed Annuity Work? 

Once a potential annuitant has explored all of the options and decided to purchase a fixed annuity, the buyer can fund his or her account in two different ways. The annuity can be paid upfront with a one-time lump sum, or purchased through a series of payments. The former payment option is much more common than the latter.

In return for the premium that the annuitant pays into the account, the insurer guarantees that the money in the account will earn a certain rate of interest during the accumulation phase, when the annuity gathers and builds up the money that will be paid out to the annuity owner. During the accumulation phase, the money in the annuity grows tax-deferred, meaning the principal accrues interest and grows within the account without any taxes needing to be paid on it. There are no taxes to be paid while the income is in the annuity, but the annuitant will need to pay taxes on distributions of the income.

The annuitant can decide when to withdraw money from the annuity or have it paid out, usually within some restrictions established by the insurance company. For example, many fixed deferred annuities will impose a surrender penalty if the annuity owner chooses to withdraw all or part of the money before a minimum period has passed. There’s more details about surrender penalties below.  

 

Fixed Annuity Payout Length and Rate

The annuity owner has another choice to make regarding the payouts, which is how long the payout phase is going to last. It is common for the annuitant to choose to receive payouts for the rest of his or her life, guaranteeing a steady and predictable stream of income to ensure that the annuity owner does not outlive his or her money. However, the annuitant also has the option to make it a fixed period certain annuity and only receive payouts for a specified length of time such as five or 10 years. Annuity owners have an additional decision to make about how frequently the payouts will occur: either monthly, quarterly, or yearly.

The rates offered on fixed annuities are derived from the yield that the insurer earns from its investment portfolio, which consists primarily of investments in high-quality government and corporate bonds. Contrary to what the name may suggest, the rate of interest earned in a fixed annuity actually can change over time. Fixed annuities pay an initial interest rate, but it is often changed each year, and there is a guaranteed minimum interest rate which is specified in the contract. The rate of interest paid out on a fixed annuity is subject to change over time, but each new rate is fixed for an explicit period of time, usually one year.

An owner of a fixed annuity can decide to add provisions to the contract that are in his or her own best interest. These add-ons include death benefits and making it a joint and survivor annuity. Death benefit provisions allow the annuity owner to designate a beneficiary to inherit any remaining annuity payouts once the annuitant passes away. That provision is an important one to include in an annuity contract because otherwise the accumulated assets will be surrendered to the insurer upon the annuitant’s death. Making it a joint and survivor annuity essentially means that the annuity applies to two people as opposed to just one. Joint life annuities continue to make payments as long as one of the two beneficiaries is alive. Adding these special options to the contract usually results in lower payouts.

 

Pros of Investing in a Fixed Annuity 

A fixed annuity provides peace of mind because it offers predictable returns for the annuitant. Since the rate does not fluctuate the way it does with other types of annuities and other investments, the annuity owner always will know exactly the return he or she should receive on the investment. 

Furthermore, fixed annuities are a safe investment because the annuitant’s principal investment is guaranteed; there is no risk of losing the money that is invested into the account. Speaking in terms of all the different types of annuities, fixed annuities offer the lowest risk. Fixed annuities offer protection from market volatility and guarantee that the owner of the account will have a dependable source of income when needed, regardless of the economic state. 

Fixed annuities offer the additional benefit of being simple, straightforward and easy to understand. There are no complicated formulas associated with fixed annuities to determine how much the money will grow, and the annuitant should be able to easily understand the provisions of his or her fixed annuity contract. 

As with any type of annuity, the money invested into a fixed annuity will grow tax-deferred which can be especially advantageous to annuitants who choose to defer their payouts and allow their principal to accumulate interest.

 

Cons of Buying a Fixed Annuity 

With low risk, comes low return. Other types of annuities that are associated with a higher risk have the potential to deliver higher returns than a fixed annuity. 

All types of annuities are relatively illiquid, making them an unwise investment for someone who may need money for a sudden financial emergency. Fixed annuities generally only allow for one withdrawal per year of up to 10% of the account value.

Additionally, the annuity will have a surrender period, during which withdrawals of more than 10% are subject to a surrender charge. The surrender period can be as long as 15 years from the start of the contract.

 

Special thanks in preparing this summary of “What is a Fixed Annuity and How Does it Work?” goes to Bob Carlson, leader of the Retirement Watch advisory service and chairman of the Board of Trustees of Virginia’s Fairfax County Employees’ Retirement System with more than $4 billion in assets.

 

Olivia Faucher is an editorial intern with Eagle Financial Publications who writes for www.retirementwatch.com.

 

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