What Is a Fixed Income Annuity & How Does It Work?

An annuity is a contract between an individual and an insurance company, designed to provide a steady stream of income, often for retirement. A fixed income annuity offers predictable returns and income payments, making it a conservative option for long-term financial planning.

Understanding Fixed Annuities

A fixed annuity is a contract issued by an insurance company that guarantees a specific interest rate for a defined period, similar to a bank certificate of deposit. This product offers principal protection, safeguarding the initial investment from market fluctuations. Unlike stocks or mutual funds, a fixed annuity removes direct market risk, providing a predictable growth path and consistent, tax-deferred growth during the accumulation phase.

This guaranteed interest rate is set for a specific term, commonly three to ten years for multi-year guaranteed annuities (MYGAs). After this period, the insurer may reset the rate, but it cannot fall below a contractually defined minimum. The stability of a fixed annuity comes from the insurance company’s obligation to provide guaranteed returns and protect the principal. This contrasts with variable annuities, where account value fluctuates, or indexed annuities, which tie returns to a market index.

The primary appeal of a fixed annuity is its emphasis on security and predictability, making it suitable for individuals prioritizing capital preservation over uncertain market returns. The guaranteed interest rate ensures funds grow steadily without exposure to stock market volatility. This distinguishes fixed annuities from other financial products that carry investment risk, forming the foundation of their utility.

How Fixed Annuities Work

Fixed annuities operate through two primary phases: accumulation and annuitization. During the accumulation phase, money contributed grows on a tax-deferred basis, with earnings untaxed until withdrawal. The insurance company applies a guaranteed interest rate, allowing the account value to compound over time, providing a significant advantage for long-term savings.

Once the annuitization phase begins, accumulated funds convert into a stream of regular income payments. These can be structured in several ways. Common payout options include “period certain” (income for a set period, typically five to thirty years), “life only” (payments for the annuitant’s entire life), or “life with period certain” (guarantees payments for life and a minimum specified duration, often 10 to 20 years, ensuring beneficiaries receive payments if the annuitant passes away prematurely).

For couples, a “joint and survivor” option ensures payments continue for both individuals’ lifetimes, typically a spouse, though often at a reduced amount. For non-qualified annuities (funded with after-tax dollars), a portion of each payment is a tax-free return of principal, with the remaining earnings taxed as ordinary income. If funded with pre-tax dollars, such as through a qualified retirement plan, the entire payment is taxable as ordinary income.

Types of Fixed Annuities

Fixed annuities are categorized based on when income payments begin and how premiums are paid. Immediate fixed annuities (SPIAs) are purchased with a single lump-sum payment and begin providing income almost immediately, typically within one year. These are often chosen by individuals in retirement who wish to convert savings into a reliable income stream. The payout amount is determined at purchase and remains fixed.

Deferred fixed annuities allow for the accumulation of funds over time before income payments commence. This type includes a growth period where the principal earns tax-deferred interest. Payments are delayed until a future date chosen by the annuity owner, often coinciding with retirement. Deferred annuities offer flexibility in funding, allowing for either a single premium payment or flexible premiums through multiple contributions.

Multi-Year Guaranteed Annuities (MYGAs) are a common deferred fixed annuity providing a guaranteed interest rate for a specific term, usually three to ten years. This rate is locked in, offering predictability for growth. At the end of the guarantee period, the owner can renew the contract at a new rate, transfer funds via a tax-free 1035 exchange, or surrender without penalty. Both immediate and deferred fixed annuities serve distinct needs: immediate income or long-term tax-deferred growth.

Key Factors to Consider

When evaluating a fixed annuity, understanding its liquidity limitations is important. Annuities are designed for long-term savings and income, not short-term liquid investments. Most fixed annuities include surrender charges if funds are withdrawn beyond a certain allowance or if the contract is terminated before a specified surrender period ends, typically three to ten years. Surrender charges usually start at a higher percentage (7-10% in the first year) and gradually decline.

Many annuity contracts permit penalty-free withdrawals of up to 10% of the account value each year. However, withdrawals of earnings before age 59½ may be subject to a 10% federal income tax penalty, in addition to being taxed as ordinary income. This discourages early access to funds. The fixed nature of payments also means inflation can reduce the purchasing power of future income over time. While some annuities offer inflation protection riders, these typically result in lower initial payments.

The financial strength of the issuing insurance company is important, as fixed annuity guarantees are backed by the insurer’s ability to pay claims. Independent rating agencies such as A.M. Best, S&P Global, Moody’s, and Fitch assess financial stability. Reviewing these ratings provides insight into the insurer’s capacity to meet long-term obligations, helping ensure the security of the annuity’s guaranteed benefits.