Fixed Annuities
byPeter Choi
Fri Mar 01 2024
Fixed annuities are a type of financial instrument that guarantees a particular rate of return. There are several types of fixed annuities; some come in the form of life insurance policies, where you make a lump-sum payment for an annuity and the insurance company pays it out to you as income over the course of your lifetime, some are long-term investments that provide a predetermined amount of income for a predetermined period of time, etc.
Fixed annuities are the most straightforward, simple, and least risky of all types of annuities available in the market. They have low fees compared to other types of annuities and provide a reliable and predictable stream of income. Generally, fixed annuities are the most relevant instruments for individuals who want guaranteed/pre-defined interest rates and a stream of income that they can’t outlive.
Types of Fixed Annuities
There are several types of fixed annuities that are available in the market. Different types of annuities fulfill different purposes, and individuals must always make an informed choice while investing in a particular type of annuity. On a very high level, we can segregate different types of fixed annuities based on TWO primary goals:
- Lifetime Income
- Principal Protection
Lifetime Income
The primary goal of an annuity is to protect the annuitant from the risk of outliving his income. We can safely assume a lifetime income annuity as longevity insurance. By taking a lifetime income plan, you are effectively transferring your risk of outliving your income to the insurance company. The insurance company creates a pool of annuitant (insured) people like you to average out early mortality and longevity, and over it, earn profits for themselves.
In these types of plans, you don’t get your principal back, but you are guaranteed by the contract that as long as you live, you will keep getting the contracted periodic payments, usually monthly or annually. For lifetime income annuities, the annuity rate (percent of your premium that you receive annually) is primarily based on your life expectancy at the time you pay the premium, and interest rates play a secondary role.
The two most popular lifetime income annuity products are:
- Single-Premium Immediate Annuities (SPIA)
- Deferred Income Annuities (DIA)
What are Single-Premium Immediate Annuities (SPIAs)?
A Single-Premium Immediate Annuity (SPIA) is an immediate annuity that starts paying an income stream immediately (without an accumulation period), typically monthly or annually. SPIA is the most popular and the oldest type of fixed annuity.
How does SPIA work?
The investor (annuitant) pays a lump-sum premium upfront and in return, the insurance company pays regular, periodic payments to the annuitant for a lifetime. The periodic payments can be monthly or annual, depending upon the contract between the annuitant and the insurance company.
The premium amount and the periodic payment amount are calculated based on several factors like your age, your gender, prevailing interest rates, and more.
Besides this, there are several riders that can be attached to a fixed annuity: Riders are additional clauses that you can take with your annuity plan. Different people have different needs, and sometimes, riders can benefit them largely. There are many types of riders. The most popular ones are Income rider, Period Certain, Death benefit, Cost of living (COLA) riders, etc.
An example of SPIA
Mr. Clarks, a male 70 years old and his spouse is 65. He has a corpus of $200,000 to invest and is looking for a lifetime income stream. He further wants that his payments are at least protected for 10 years; even if he dies during this time, the remainder of payments must go to his wife. The rates are calculated for annuities beginning in the year 2021.
In this case, below are the approx annual payout Mr. Clarks will get in Single Life Man, Single Life Woman (Wife), and Joint Life immediate annuity plans, respectively, for different companies. Note that in Joint Life Policy, there is a “period certain with life” clause that promises a minimum payment of 10 years. If Mr. Anthony dies during this 10 year period, his remaining payments will go to his wife.
| Plan Type | Annual Payout Rate | Annual Payout (in $) |
|---|---|---|
| Single Man Life | Between 6.50% - 6.80% | $13,000 - $13,600 |
| Single Woman Life | Between 6.20% - 6.40% | $12,400 - $12,800 |
| Joint Life with period certain | Between 5.10% - 5.30% | $10,200 - $10,600 |
Approximate Payout in SPIA
What are Deferred Income Annuities (DIA)?
Deferred Income Annuity (DIA) is an annuity that begins paying income at a future date that is agreed in the contract. One benefit of deferred annuities is that they help in providing tax-advantaged savings. With a deferred annuity, you begin receiving payments years or decades in the future. In the meantime, your premiums grow tax-deferred inside the annuity.
How does DIA work?
A DIA works very similarly to an SPIA, with the major difference that SPIA begins paying income at a future date that is agreed in the contract. In the meantime, your premiums grow tax-deferred inside the annuity. Because the premium grows tax-deferred inside the annuity you get higher payouts in the future.
An example of DIA
Mr. Clarks is 60 years old and his spouse is 55 years old, and he enrolls into a deferred income annuity and will start receiving annual payouts beginning 10 years from now (when he is 70 years old).
| Plan Type | Annual Payout Rate (after 10 years) | Annual Payout (in $) (after 10 years) |
|---|---|---|
| Single Man Life | Between 9.20 %- 9.50% | $18,400 – $19,000 |
| Single Woman Life | Between 8.50% – 8.75% | $17,000 – $17,500 |
| Joint Life with period certain | Between 7.05% – 7.30% | $14,100 – $14,600 |
Approximate Payout in DIA
Note that these annual payout rates are an approximate range for the given situation in the year 2021. These rates vary slightly across different companies and different locations. We can see that in DIA, the payouts are higher than in SPIA because we deferred our income in the future.
Another type of lifetime income annuity is Qualified Longevity Annuity Contract or QLAC. A QLAC is similar to a deferred annuity, but it is funded only from a qualified retirement account or IRA. One unique benefit of QLAC is that you can defer the payments until the age of 85. The more you defer the payments, the higher the payments insurance companies will pay out to you once the income stream is started.
Principal Protection
SPIAs and DIAs don’t offer principal protection by default, so it may not be the best annuities for investors who are looking for principal protection. One type of fixed annuity that offers principal protection is Multi-Year Guarantee Annuities (MYGA).
Multi-Year Guarantee Annuity (MYGA)
MYGA is the simplest form of annuity available in the market. It is pretty similar to a bank Certificate of Deposits (CD).
How does MYGA work?
A Multi-Year guarantee annuity (also known as a fixed-rate annuity) is a contract that is paid for with an initial lump-sum premium. The contract lasts for a certain time span, which is called the contract term. Usually, MYGA annuities last for 3-10 years. With the annuity, a fixed interest rate is declared in advance.
Generally, this interest rate remains the same throughout the contract term. The insurance company provides a guarantee for this growth and credits interest to the MYGA annuity on an annual basis. In turn, the money grows tax-deferred within the contract. Even if the MYGA annuitant dies, the beneficiaries can withdraw the full account value without incurring any surrender fee.
What is the basic difference between MYGAs and CDs?
MYGA, although very similar to CD, they usually offer higher interest rates than CDs, but unlike CDs, they are not insured by FDIC.
5 Reasons To Invest in Fixed Annuities
The annuity industry is not what it used to be. It is now a more competitive market, in which low-cost providers are able to offer the same or better products for lower fees. In this competitive environment, fixed income annuities can provide comfort that you will have your future needs met with a guaranteed stream of income.
Below are the 5 reasons why you should invest in Fixed Annuities:
Guaranteed and Predictable Fixed Income
The primary feature of any fixed annuity is that the income stream arising out of that annuity is always guaranteed and predictable. The insurance company will tell you in advance about the interest rates, interest payments, and the periods in which you will get the payouts.
In SPIAs and DIAs, you will know in advance the monthly or annual payments that you will get for your lifetime, and in MYGAs, you will know in advance the interest rates and tenure of the annuity, and the exact date on which you will get both your principal and interest back.
Guaranteed and Predictable payments help you to better plan your retirement as compared to variable payouts. This is not a feature in variable and indexed annuities.
Fixed Annuities are Tax-Deferred Investments
Fixed annuities can offer complete tax deferral on interest earned, so all your earnings can grow tax-deferred until the funds are withdrawn. This provides increased earnings potential due to compound interest (your interest earns interest)
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Lowest Risk
In fixed annuities, we already know the interest rates and the payouts in advance. Thus, making it a great way to gain guaranteed returns for retirement while protecting yourself against the volatility of the stock market.
Principal Protection
Fixed annuities such as MYGAs offer principal protection, meaning that we are always guaranteed that we will get our initial principal payment back when the policy matures.
Simple and Straightforward instrument
Unlike variable and indexed annuities, fixed annuities have straightforward rules and formulas for determining the amount of money you will receive in income payments. You will get everything in writing before you sign for the policy. This makes fixed annuities the most simple annuity instruments available in the market.
Cons of Investing in Fixed Annuities
Investing in Fixed Annuities may not be a good idea for everyone as it has its own set of cons. For instance, it entails long lock-in periods of up to 30 years which is an inconvenience for people who need their money at a short notice.
Moreover, the investment options are too limited and any gains can be offset by fees and charges (early withdrawals, surrender charges, etc). The annuity rates are also often low and the returns may not be competitive with other investments. Also, the low rates may not keep up with the inflation, meaning that their real (actual) value may decline over time.
Are fixed annuities risk-free and guaranteed?
Every fixed annuity contract comes with a minimum guarantee rate/payout. The interest/payout on your fixed annuity will never dip below that minimum rate. In MYGAs, the company also guarantees the return of the principal invested.
But, it is important to understand that all guarantees and protections offered by fixed annuities are subject to the claims-paying capacity of the issuing insurance company. Unlike CDs, fixed annuities are not guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other federal insurance agency. But, they are regulated and guaranteed to a certain extent by the individual state insurance guarantee fund. You should always enquire about your state guaranty association before making the decision to buy fixed annuities.
How are Fixed Indexed Annuities (FIAs) different from Fixed Annuities?
Fixed Index Annuity is a hybrid product that contains features of both Fixed and Variable Annuities.
Fixed Index Annuities are contracts between the annuitant and an insurance company in which the insurance company promises to credit interest based on the performance of a certain stock market index. Fixed Index Annuities has an inbuilt feature of capital protection, so even if the index goes down, your principal will remain safe.
Although FIA seems very similar to Fixed Annuity, the subtle difference between them is that in a fixed annuity, we know in advance, the total amount of interest payments that we will get, whereas, in FIA, we only know that our principal is safe and the worst-case scenario is that we do not get any interest credited (if the underlying index falls) in a particular period.