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What is a fixed annuity and how does it work?

Accumulation and distribution

Fixed annuity example

Types of fixed annuities

Fixed annuities vs. variable annuities

The bottom line

LearnAnnuitiesWhat is a Fixed Annuity & How Does It Work?

What is a Fixed Annuity & How Does It Work?

Jun 21, 2022


7 min read

Fixed annuities offer investors the security of a locked-in interest rate and the protection of their premium. They can play a key role in retirement planning.

Those who want to save for a long-term objective or to lock in a regular income stream often consider an annuity, a kind of financial product that allows an investor to build savings that grow tax deferred until they are ready to start drawing on this nest egg. Annuities can play a key role in retirement planning.

There are various types of annuity investments, and fixed annuities are one of the most common and least risky. The reason? They guarantee they will pay a predetermined minimum interest rate for a specified period while protecting an investor’s principal.

What is a fixed annuity and how does it work?

A fixed annuity is a contract in which the holder makes contributions to an account that grows tax deferred, pays a fixed interest rate, and safeguards the investor’s principal to provide a guaranteed return when the holder collects their payout.

Some people think of fixed annuities as insurance against outliving their savings. In fact, fixed annuities are sold mainly by insurance companies and they are classified as insurance products, rather than investment securities. They are thus regulated by state insurance commissions but not federal agencies.

The sellers base fixed annuity contracts and the interest rates they pay on several factors, including: 

  • The investor’s current age
  • The age when they’ll start withdrawals
  • Life expectancy
  • Contribution amount
  • Time period
  • The provider’s expected rate of return

Individuals contribute to the annuity through regular premium payments or a lump sum. The provider invests the buyer’s funds in a portfolio of bonds and other stable, fixed-income securities. Meantime, the principal is protected from declining and the money in the annuity grows tax-deferred. The company selling the annuity makes a profit by paying the annuity holder less than the return it expects to earn on the invested money. 

When the annuity holder is ready for the payout, they frequently choose to “annuitize” their nest egg into a stream of guaranteed regular income, like a pension payment. The disbursements can be structured to last for a set number of years, or for the investor’s remaining lifetime.

Accumulation and distribution

Fixed annuity investments have two phases: accumulation and distribution.

Accumulation starts when the investor signs the fixed annuity contract and begins making contributions. The period runs until the individual begins receiving the annuity payment as the contract outlines.

Accumulation can take decades, depending on when the holder buys the annuity and how much in savings they want at its end. Investors can use online annuity calculators to determine the annuity’s growth based on how much they deposit over time. 

The investor withdraws their money in the distribution phase. The annuity provider calculates the payments based on how much money is in the account and how long the payments will continue. Investors face a 10% penalty for withdrawing funds before they turn 59 ½.  

When the investor makes withdrawals, the amount they initially contributed to the annuity is not taxed if it was made with after-tax dollars. The earnings on the investment gains are taxed at the individual’s regular income tax rate.

Fixed annuity example

Investors can see the details of a fixed annuity by using a fixed annuitycalculator that considers the investment amount, interest rate, and time period. For example, someone who invests $2,000 a year for 10 years at a fixed 3% interest rate will wind up with $23,615.59.

Calculators can also determine the monthly payout rate. With a $20,000 investment that has a 3% total rate of return, the investor could withdraw $192.75 per month over 10 years.

Types of fixed annuities

Although all fixed annuities share certain defining characteristics, there are also a number of different ways they can be structured. Below are some of the most common ones.

Immediate or deferred?

Annuity investors must decide between two basic configurations—immediate and deferred.

People who want to begin receiving payments right away can choose an immediate fixed annuity, also called a single premium immediate annuity, or SPIA. 

These annuities don’t have an accumulation period. Investors generally fund them with a lump sum from a savings account, 401(k), or individual retirement account (IRA). The provider agrees to pay a consistent, set amount for the holder’s life or a specified term and makes the payments on a regular basis, like a pension. The investor can begin receiving the payments as soon as 30 days after signing the contract and must begin taking them within the first year.

People who want to receive payments further down the road can choose a deferred fixed annuity. These annuities require payouts to begin at least one year after the initial investment, but they typically accumulate funds for up to 30 years. Investors can choose both lump sum and annuitized options for their payment.

Life or term-certain?

Annuity buyers also must consider what happens to their investment when they die—and whether they should purchase a life or a term-certain fixed annuity.

Life annuities make payouts for as long as the holder lives; the insurance company usually keeps the remaining funds when the owner dies. Some life annuities let the holder arrange for a beneficiary to receive the remaining annuity payments, usually as a lump sum.

Term-certain annuities make payments for a set time period, which could end while the holder is still alive. If the owner dies before the contract ends, the insurance company usually keeps the remaining money.

Annuity providers can build all types of conditions and variations into the contracts they sell.

Despite the “fixed” label, a fixed annuity’s interest rate can change. For instance, a 10-year contract may offer a fixed rate for the first five years and let the rate fluctuate for the remainder. In comparison, a fixed annuity known as a multi-year guaranteed annuity, or MYGA, guarantees a fixed rate for the entire period.

Benefits and drawbacks of fixed annuities 

Fixed annuities can be a useful tool to help investors prepare for retirement, though they do have some downsides. Fixed annuity pros and cons include: 

Potential advantages of a fixed annuity

  • Guaranteed minimum interest rate

    : Investors receive a set minimum interest rate for the duration of the investment.

  • Premium protection

    : The value of the investment will not decline.

  • Low risk

    : Interest is predetermined and not dependent on an investment portfolio.

  • Lifetime income

    : Investors won’t outlive their funds with certain annuities.

  • Simplicity

    : Fixed annuities make it easier to understand terms and payments.

  • Predictable

    : The investor knows what they will be getting and when.

Potential disadvantages of a fixed annuity

  • Provider stability

    : Insurance company issuers vary in quality and longevity.

  • Fewer guarantees

    : Fixed annuities are not guaranteed by federal agencies.

  • Limited returns

    : Investors receive a specified return regardless of how well financial markets perform.

  • Higher taxes

    : Earnings are taxed as ordinary income not lower long-term capital gains.

  • Penalties

    : Investors face penalties for withdrawing funds before age 59 ½ and outside of contract terms.

  • Inflexible

    : It may be difficult to access funds while the contract is in force.

  • Costs

    : Inventors usually get less than prevailing market returns and pay extra for various riders and exceptions.

Fixed annuities vs. variable annuities

Fixed annuities differ from another popular investment product known as variable annuities in key ways. 

  • Interest rates change.

    A variable annuity typically is invested in stock, bond, and other mutual funds; some may invest in exchange traded funds (ETFs). The interest rate the annuity pays fluctuates based on the performance of the composition of the investment portfolio the investor selects.

  • Returns aren’t guaranteed.

    Variable annuities do not include an interest rate floor, meaning a specific return isn’t guaranteed as it is in a fixed annuity. 

  • Regulated.

    Unlike their fixed counterparts, variable annuities are regulated by federal watchdogs including the Securities and Exchange Commission as well as state insurance commissions. 

Fixed-indexed annuities

take a hybrid approach that combines features of fixed and variable offerings. These products are linked to a financial index such as the Standard & Poor’s 500 Index. Their interest rate will not rise above a specified cap, no matter how well the index performs. But the rate also will never fall below zero, meaning the principal is protected.

The bottom line

Fixed annuities offer investors the security of a locked-in interest rate and the protection of their premium. People often consider these annuities to provide a regular stream of income or a lump-sum payout for their retirement years. A fixed annuity is the least complicated choice for individuals seeking this type of investment. The investor knows exactly what they’ll be getting and when.

Even so, these annuities can have provisions that limit an investor’s ability to change course. They can be difficult and expensive to modify. They don’t offer protection against rising inflation or allow an investor to gain beyond contract stipulations during rising financial markets. Investors are generally stuck with a fixed annuity’s terms and conditions—for better or for worse.

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