Annuities come in three categories: fixed, variable, and indexed annuities. Each annuity type has its advantages and shortcomings, and it is important to understand what you are getting into before signing the contract. Here is an overview of the pros and cons of a fixed annuity.
Pros of Fixed Annuities
Fixed annuities offer many notable benefits, including:
1. Assured Returns
Fixed annuities pay out fixed interests, regardless of the financial markets’ performance. Fixed payments mean that your returns are also fixed and guaranteed, a crucial factor for cautious investors to consider.
2. Guaranteed Income
Fixed interests and returns also mean that your income is fixed and guaranteed. Notably, the financial markets’ performance will not affect your payments.
Cautious investors concerned about losing their investment can also ease their minds because this outcome is highly unlikely. Ideally, the insurance can only default on your payments if it becomes bankrupt or goes out of business. However, regulators require insurance companies to maintain large cash reserves (larger than banks) to pay their liabilities.
3. Flexible Payout Plans
Fixed annuities also offer flexible payout plans. Most insurance companies offer three payout plans based on three crucial factors:
You can choose when you want to withdraw your money at your convenience. The timing doesn’t matter – it can be today or several decades in the future. The flexible timing is convenient for investors who may need quick access to their money for financial emergencies.
The insurance company holding your annuity can pay you income generated from your principal as one lump-sum payment or a series of payments. You have three payment length options:
- Straight Life – You get consistent monthly payments for the rest of your life.
- Joint Life – You get consistent monthly payments for the rest of your and your spouse’s lives.
- Lump-Sum Payments – You get one lump-sum payment when you decide to surrender your annuity.
It is important to pick the best option for your needs because you cannot change your payment length option after you choose one. It is also worth noting that lump-sum payments may incur a 10% early withdrawal penalty or surrender charges.
It is advisable to consider a period guarantee if you opt for a straight life payment length option. A period guarantee is written assurance from the insurance company that your beneficiaries will continue getting payments if you die unexpectedly within a particular period – ordinarily, your annuity would be null if you died before surrendering it. Most insurance companies offer period guarantees over progressively incremental periods, usually starting from ten years.
4. Affordable Investment Minimums
Fixed annuities also set lower investment minimums than variable and indexed annuities. Ideally, investors can get started with less than $1,000, making fixed annuities affordable for ordinary investors and individuals worried about their financial security or retirement plans.
5. Tax-Deferred Growth
The money you pay towards your annuity policy will grow tax-free until you decide to withdraw it or start receiving payments. The IRS will then tax your withdrawals and payments based on an exclusion ratio. You can also use an annuity policy to supplement your tax-free savings if you have contributed the maximum amounts to your IRA and 401K.
Cons of Fixed Annuities
Unfortunately, fixed annuities also come with several notable shortcomings, including:
1. Low Returns
A fixed annuity’s returns are very low compared to variable and indexed annuities and other investment assets. It is also worth noting that many insurance companies also offer teaser rates to incentivize their potential clients. Essentially, teaser rates are relatively higher returns guaranteed for a limited period, usually several years, after which the standard low returns apply. However, it is worth noting that the fixed returns help offset this disadvantage.
2. Limited Flexibility
An annuity’s flexibility only applies to its accumulation and withdrawal periods. An annuity’s accumulation period is the time spent making payments towards your principal without requesting withdrawals, while its withdrawal period is the time spent receiving payments or making withdrawals.
An annuity policy is flexible during the accumulation period because you can withdraw all of your money (including the principal). However, it is worth noting that you may incur charges and penalties for surrendering your annuity policy prematurely.
Unfortunately, this flexibility ends immediately when the withdrawal period begins. This means that the insurance company owns your principal, and you can only receive the agreed-upon serial or lump-sum payments.
3. Limited Protection against Inflation
Rising inflation is also a problem for fixed annuities. Inflation increases the overall cost of living and causes money to lose its value, decreasing its purchasing power. For example, a 2% inflation rate over 30 years would reduce the purchasing power of $1,000 to only about $550. Unfortunately, fixed annuities pay a fixed income – the payments may cover your cost of living today, but they will be insufficient in the future if inflation keeps rising.
However, it is worth noting that some fixed annuities also offer inflation protection. However, this feature requires higher payments and offers considerably lower serial or lump-sum payments than an ordinary fixed annuity policy, making the protection somewhat limited.
4. Fees & Commissions
Fixed annuities also charge notably higher fees and commissions than indexed and variable annuities. The most notable charges include:
- Surrender Charges
Most insurance policies charge a penalty for surrendering your annuity policy prematurely. It is worth noting that surrender charges are regressive, meaning that they decline as your annuity policy nears its maturity date.
- M&E Charges
M&E stands for mortality and expense. Insurance companies deduct M&E and administration charges from your annuity policy’s interest.
Financial advisors and insurance representatives get commissions for recommending annuity policies. The insurance company pays this commission, but some companies factor the cost into their clients’ overall charges.
A fixed annuity is an excellent investment option if you seek long-term financial stability. However, it is important to weigh your annuity policy’s advantages and shortcomings to ensure that it suits your needs and preferences.
Amerus Financial Group offers client-friendly annuity policies across all categories. Get in touch or visit our website to learn more about our annuity policies or request a free guide on fixed annuities.