A fixed annuity is an insurance contract in which the issuing company promises to make fixed dollar payments to the contract holder, the annuitant, for a pre-determined length of time. In return for payment of the contract premium, the issuing company also guarantees both the earnings on the account and the principal balance.
In this article, we're first going to review the fundamental concepts of an annuity. Then we're going to talk about the pros and cons of investing in a contract. Next, we're going to discuss how fixed annuities are designed. Finally, we're going to explain some of the features you might find in a contract, including payment terms as well as fees.
Most annuities are written contracts issued by life insurance companies. In exchange for payments of the contract premiums, the contract holder (annuitant) can expect to receive a series of regularly scheduled payments.
Buying an annuity should not be confused with purchasing life insurance. It's also not a savings account, and it is typically used to supply long-term retirement income. Because the insurance company guarantees both earnings and principal, the investment is as safe as the financial strength of the insurance company.
Some of the benefits of annuities are listed below:
Some of the disadvantages of purchasing an annuity include:
Annuities offer contract holders the benefit of tax-deferred growth on their money. For example, the earnings on the money placed in an annuity grow on a tax-deferred basis until withdrawn. By deferring taxes, the contract holder may be able to accumulate more retirement funds over a shorter period, ultimately providing more retirement income. However, if a contract is surrendered (redeemed), then a tax penalty may apply.
When a fixed annuity contract is in its accumulation period, the investment will earn a rate of interest as specified by the insurance company. The contract will usually show both a minimum, or guaranteed, interest rate in addition to a current, or declared interest rate.
The guaranteed interest rate is just that: a minimum rate of interest the contract holder will earn on their investment that is guaranteed by the insurance company. The current, or declared, interest rate is used by the insurance company to calculate income payments in the current period.
As is the case with variable annuities, fixed annuities will typically offer the contract holder options for the way benefits are received, as well as how the premiums are paid. For example, there are:
There are two ways the benefits, or payments, are received from an annuity. With an immediate annuity, payments begin shortly after the premium is paid. With a deferred annuity, the income stream is received at a future point in time.
Immediate annuities are used when the contract holder is looking to obtain a steady source of income in the near term. This type of annuity is usually purchased by an individual looking for a stable source of retirement income.
If the investor is looking for a way to amass money on a tax-deferred basis, then a deferred annuity is chosen. This type of contract allows the annuitant to defer the payment of income tax until the money is needed at a future point in time.
Contract holders usually have two options when it comes to making premium payments on an annuity: single premiums or installment payments. With a single premium contract, the annuitant is expected to pay the insurance company one premium.
Installment premiums tend to be associated with more flexible annuity contracts. The contract holder might be obligated to make certain minimum payments on a loosely defined schedule. On the other hand, an installment premium might also be defined as a very specific series of payments that are due on a predetermined schedule.
As is the case with any competitive marketplace, different insurance companies will offer fixed annuities at a variety of costs. That being said, the following factors typically determine the premiums paid on an annuity:
The value of any fixed annuity can be calculated by using premiums paid, subtracting contract fees or charges, then adding back interest credited to the account. Using this relatively simple formula, the insurance company can determine the benefits paid to the contract holder.
There are many different charges, or fees, a company may impose as part of the fixed annuity contract. Some annuities are sold with front-loads (which require fees to be paid at the start of the contract), while others are back-loaded (which require fees to be paid later). Finally, a contract might also spread the fees evenly over the life of the annuity.
Buying an annuity is an important decision, so it's vital to understand the charges or fees that could affect the premium payments / income benefit. Contracts may include the following fees / charges:
Most annuities allow the contract holder to surrender the contract if income benefits have not yet been received. A contract is terminated when surrendered, and the money received for the contract is its present value less the surrender fees. Under certain conditions, the amount received at surrender could be less than the amount paid into the annuity.
The surrender charge is normally stated as a percentage of the contract's value. In some cases, this percentage will reduce over time and / or as the account balance grows. The surrender charge could also be stated as a reduction in the interest rate.
The last topic we're going to cover is perhaps the most important: the benefits paid by a fixed annuity contract. The income payments are normally received on a monthly basis, although it is possible to find payment terms of varying frequencies. As mentioned earlier, the amount received will depend on factors such as age, gender, contract features, as well as the account's value.
The annuity contract itself will contain a table of both guaranteed rates and current rates. These interest rates can be modified by the insurance company at any time. The guaranteed interest rate will serve as a floor rate. The rate cannot go lower than this level.
Generally, there are four types of fixed annuities in the marketplace:
Laws exist in many states that allow the buyer of an annuity a certain number of days to evaluate the investment after purchase. If the buyer decides they do not want to keep the annuity, then they can return the contract and receive a full refund. This type of arrangement is called a "right to return" or "free look" period. If the law allows for this free look period, this feature will be prominently described in the contract.
About the Author - Fixed Annuities (Last Reviewed on October 19, 2016)