Fixed annuities, generally speaking, are annuity products that give the purchaser of the annuity the guarantee of fixed income payments for life.
Annuities must come with the option to be paid out in equal payments either over a certain number of years or the lifetime(s) of the annuitant(s). This is the case for variable and fixed annuities, and these payments will be fixed and guaranteed. Where they differ is how they are invested before any annuitization takes place.
Fixed annuities are built with funds held in the general account of the insurer, pooled in a portfolio comprised of mostly conservative instruments such as government bonds and investment-grade corporate bonds, and having substantial reserves that adhere to federal requirements for life insurance companies: in short, they are invested very safely.
The insurer determines the payout rate on the lifetime or period income using the skills of actuaries and the company history of mortality experience with their clients. The guaranteed interest rate on their fixed annuities is determined in a similarly conservative fashion.
Investors do not bear any of the investment risk in fixed annuities: the insurance company alone is responsible for turning out the guaranteed growth or payments that they have promised.
Fixed annuities can come in several forms.
One is a fixed period annuity, which may be held for 2-10 years, and gives investors a conservative growth rate much like bank CDs. After the period is up, the investor will usually find another similar annuity, or cash out and pay taxes on the gains.
Note that annuities are considered retirement investments by the IRS, and withdrawals may be subject to early withdrawal tax penalties if taken out before age 59 ½.
Income annuities are another kind of fixed annuity, in which there is little-to-no liquidity, and the only thing the investor will ever get out of it is set payments for the rest of his or her life. If it is purchased with a lump sum, as from a 401(k) rollover, and the income stream starts immediately, it is called a Single Premium Immediate Annuity, or SPIA.
A deferred income annuity puts off income payments for anywhere from 2-30 years in the future. These can be purchased with a lump sum or regular investments. The guaranteed payout will be determined by the rates prevalent at the time of the investment and the amount of time until the income starts.
The longer an investor can put it off, the higher the payments will be. This is because annuity income payments are based around life expectancy, which a bit of interest sprinkled on top, and the company assumes that ½ of the annuitants will outlive their life expectancy.
There are also annuities that combine the deferred income annuity and the period annuity, giving the investor access to cash before income is taken, or allowing the investor to only turn on an income stream using part of their accumulated value.
In such contracts, the investor is entitled to one rate of return on an accumulation value which is somewhat liquid to him or her, and another rate of return on what is often referred to as an income-base.
The insurance company wants the client to leave the money with the company, so the interest rate on the income base amount will be higher, and it represents a theoretical value upon which the income stream will be calculated.
There may also be surrender charges on the accumulation value, to discourage the client from pulling money out too soon.
The company needs a long period of predictable funds to use the long-term bonds and whatnot that it needs to preserve the safety and competitive rate of return that the General Account needs. Fixed annuities is a term that also encompasses indexed annuities.
Indexed annuities used to be more popular, but their long surrender periods and lackluster performance have generally made them undesirable. Still, various indexed annuity products are competitive in the market today.
These give them investor the chance for higher upside potential by using a very small part of the general account’s gains toward the purchase of derivatives such as calls, puts, and futures that seek to profit from the movements of major indices. The client can even choose which index to invest in, or multiple indexes in a simulated portfolio.
The agents who sell indexed annuities, however, do not have to be securities-licensed and may not fully understand the product themselves, since it is a very confusing product.
What is a Variable Annuity?
What are the Different Types of Annuities?
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