What Do Fixed Annuities Offer & How Do They Work?

A fixed annuity is a contract between an individual and an insurance company, designed to provide a guaranteed stream of income. This financial product offers a predictable return on contributions, often serving as a component of a retirement strategy.

Fundamental Features of Fixed Annuities

Fixed annuities offer contract holders a guaranteed interest rate on their contributions. This rate is typically set for an initial period, such as one to five years, and then may be reset periodically by the insurance company. However, the contract usually includes a minimum guaranteed interest rate, ensuring that the return will not fall below a specified level, providing predictability for the annuity’s growth.

A significant feature of fixed annuities is principal protection, meaning the initial investment is safeguarded from market downturns. This security is maintained because the insurance company typically invests the principal in conservative assets, such as high-grade corporate and treasury bonds, which provide a stable income stream.

Earnings within a fixed annuity grow on a tax-deferred basis, which means taxes are not due until withdrawals are made from the contract. This allows the interest to compound without immediate taxation, potentially leading to greater accumulation over time. When funds are eventually withdrawn, they are typically taxed as ordinary income, and withdrawals made before age 59½ may be subject to an additional 10% federal tax penalty on the taxable portion.

Fixed annuities are generally considered long-term financial products, and liquidity is a consideration for contract holders. Most fixed annuities permit penalty-free withdrawals of a limited percentage of the account value annually, often around 5% to 10%. Larger or earlier withdrawals beyond these limits, particularly during the initial years of the contract, may incur surrender charges, which are fees imposed by the insurance company. These surrender charge periods can last for several years, commonly ranging from five to ten years.

Income Distribution from Fixed Annuities

Fixed annuities can provide income to the contract holder through a process called annuitization. Annuitization converts the accumulated value of the annuity into a series of regular, periodic payments. Once an annuity is annuitized, the decision is generally irreversible, meaning the contract holder commits to receiving payments based on the chosen schedule and cannot typically access the remaining lump sum.

The amount of each payment is determined by several factors, including the annuity’s accumulated value, the contract holder’s age, and the chosen payout option. Various income stream options are available upon annuitization, allowing for customization based on individual needs. One common option is “Life Only,” where payments continue for the annuitant’s lifetime but cease upon their death.

Another option is “Period Certain,” which guarantees payments for a specific number of years, such as 10 or 20 years. If the annuitant dies before the period ends, the remaining payments are made to a designated beneficiary. A “Life with Period Certain” option combines these features, providing payments for the annuitant’s life but guaranteeing payments for a minimum period even if the annuitant dies earlier.

For those seeking to provide for another individual, a “Joint and Survivor” payout option is available. This option ensures that payments continue for the lives of two individuals, typically spouses. Payments generally continue as long as at least one of the annuitants is alive.

Common Variations of Fixed Annuities

Fixed annuities come in several forms, each designed to meet different financial planning needs. A common type is the Fixed Deferred Annuity, which has two distinct phases: an accumulation phase and a payout phase. During the accumulation phase, the money contributed to the annuity grows on a tax-deferred basis at a guaranteed interest rate. The payout phase begins at a specified future date, often in retirement, when the contract holder starts receiving income payments.

Fixed Immediate Annuities, also known as Single Premium Immediate Annuities (SPIAs), operate differently. These annuities are funded with a single lump sum payment, and income payments begin almost immediately, typically within one year of purchase. SPIAs are often chosen by individuals who are already in retirement and require an immediate, predictable income stream.

Multi-Year Guarantee Annuities (MYGAs) are a specific type of fixed deferred annuity that offers a guaranteed interest rate for a predetermined number of years. These terms can range from typically three to ten years, providing rate certainty for the entire duration of the guarantee period. Unlike some standard fixed annuities where the interest rate might adjust more frequently after an initial guarantee, MYGAs lock in the rate for the full multi-year term.