Fixed Annuities Pros and Cons
Fixed annuities represent a contract between an individual and an insurance company. Annuities provide a contractual way for an individual to guarantee that he or she receives income for life. Other financial products like equities that pay dividends can also provide income. But the income is not guaranteed. A fixed annuity will guarantee that an individual will have a stream of income as long as he or she lives.
Deferred Fixed Annuities Pros and Cons
Like all annuities, except those that are immediate, deferred fixed annuities have two phases. The first phase is the accumulation phase. During this phase, which can be as short as a few years or as long as several decades, the annuity owner makes regular deposits into the account. These deposits are known as premiums. If the deferred fixed annuity is part of a company sponsored defined contribution plan, the premiums can be deducted from the investor's paycheck. Premiums can also be paid directly to the life insurance company if the investor wishes to purchase the annuity outside of his or her employer's plan.
All premiums contributed to a deferred annuity grow tax-deferred. Deferred annuities can be purchased with either pre or post-tax dollars. Pre-tax dollars are dollars that are contributed to tax-qualified account, like a 401(k) plan. Post-tax dollars are those that have been taxed. For example, even though a Roth IRA is a retirement savings account, it is funded with post-tax dollars. Whether the deferred fixed annuity is bought with pre or post-tax money, it usually grows much faster than an account that has taxable earnings.
When an annuity owner, who is known as the "annuitant", decides to have distributions start, the annuity is “annuitized”. The distributions can be paid monthly, quarterly or annually, depending on the preferences of the annuitant. An annuitant should think about his or her distribution schedule very carefully, because once it starts, it cannot be changed. An insurance company will also typically let the annuitant choose the length of time over which the distributions are paid. Guaranteed payments can be taken for life or for a certain number of years. The selection will affect the amount of each payment.
Under current federal tax law, an annuity owner cannot begin taking payouts prior to age 59 ½ without incurring a 10% penalty. Retirement account distributions must begin in the year in which the annuitant turns age 70 ½.
What are Immediate Fixed Annuities?
An immediate fixed annuity is funded with a single premium. The premium is typically after-tax money that is from a savings or checking account or the death benefit from a life insurance policy. It can also be from the mandatory distributions taken on a qualified account. The distributions made by the life insurance company begin immediately, typically within 12 months of the start of the contract.
Immediate Fixed Annuities Pros and Cons
The return paid on fixed annuity is always fixed. It could change year over year, but once it's set for the year it will not change because of stock market fluctuations. This can be of great help to those on a tight retirement budget. They will know exactly the amount of each payment that will be made. While the rate paid on a fixed annuity could vary from year to year, most insurance companies will guarantee a rate of between 3% and 5%. It's important to note, however, this guaranteed amount might not be enough to offset any cost of living increase. Inflation is a real and significant threat to retirement savings.
A COLA (cost of living adjustment) rider ensures that inflation will not cut into a retiree's future purchasing power. A cost of living adjustment rider increases the price of the fixed annuity contract, but it will increase the amount of money that is paid out each year. The amount should be enough to counteract inflationary pressures.
Another risk factor associated with a fixed annuity is the premature death of the contract owner. If an annuitant dies before he or she has been repaid the amount he or she paid in premiums, the insurance company will keep the balance. To offset this, most insurance companies now give a guarantee of some sort on the premium. This amount is of course, less charges and fees. For example, if the annuitant has an annuity worth $300,000 and dies after having only received $50,000 back, the beneficiary will receive the remaining $250,000. Or, the annuitant can choose an option called “period certain”. If he or she chooses a period of 20 years but dies during year 10, the beneficiary will receive payouts for the remaining 10 years.
Based on the Pros and Cons, Who Should Buy Fixed Annuities?
Retired investors who need to guarantee income for life or for a set amount of time are often advised to consider a fixed annuity. Retirees who rely on equity dividends for most of their income may also want to consider a fixed immediate annuity. Dividends can provide substantial income but are not guaranteed. They can be cancelled by the company at any time should it need to conserve cash.
A retired investor may also fear that he or she will outlive the money he or she has saved. An immediate fixed annuity will also provide financial security. The payouts will be guaranteed for as long as the annuitant is alive, regardless of the amount of the premium. Even when the amount of the payouts exceeds the premium, the insurance company is obligated to make the payouts. For those in good health with few liquid assets, a fixed annuity can make a difference in their standard of living.
A fixed annuity investor should always make sure he or she has enough cash for emergencies. As outlined earlier, an annuity contract cannot be cancelled except under the extreme circumstances. Once the contract is signed, the only way an investor can receive his or her money is through the payouts. Keeping enough liquid cash in a savings, checking or money market account to cover unexpected expenses is prudent.
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