All About Fixed Annuities
A fixed annuity is a type of insurance contract that is designed to provide some sort of guarantee. Whether it is a guarantee of the principal balance of the annuity, or a guarantee of a specific interest rate, or a guarantee of a future income stream. Now as you probably know from reading the site and/or watching the videos, there are lots of different types of annuities and they all behave differently. This isn't a post about a variable annuity, or an indexed annuity, we're specifically talking fixed annuities here so keep that in mind while you read.
Fixed Annuities Vs. CDs - similar but not the same
One of the key benefits of a fixed annuity is that it provides a guarantee of your principal. The easiest point of comparison is a CD (certificate of deposit) from a bank. A big important note: Fixed Annuities are not CD's. They are not issued by a bank and therefore they are not covered by FDIC insurance. They are issued by an insurance company and the guarantee comes from that company.
That being said, just like a CD a fixed annuity has a specific term, a principal guarantee, and an interest rate that the company agrees to pay. This can be particularly appealing to folks who are concerned with potential loss of principal and don't want to have to worry about market risk. They may want a greater return than money in the bank, as typically a fixed annuity offers a higher rate than say a savings account, without having to worry about your balance fluctuating due to market performance. For a conservative investor a fixed annuity can be a valuable tool to earn a higher return than typical cash accounts, without crossing the threshold into investments with higher risks associated with them, like stocks or mutual funds.
One key difference between a fixed annuity and a CD is in the taxation of your gains, of the interest that you earn. In a non-retirement CD you pay taxes each year on the interest that the bank pays you. In a non-qualified annuity however (one purchased with after tax money) you don't pay the tax on the interest as you earn it, you tax when you draw it out of the account. This allows your money to compound more effectively without suffering from something called tax drag. It also gives you control over when you choose to pay the taxes, as you can simple leave the gains in the account to defer if you don't need them, and therefore defer any tax liability until a future date.
While fixed annuities can be a valuable addition to a retirement income strategy, it's important to be aware of their limitations as well. For example, fixed annuities typically have surrender charges, which can be substantial if an individual withdraws the funds prior to the end of their term. Lastly -fixed annuities are designed to compete with more volatile investments like stocks. They are a more conservative investment and as a result the interest paid on them is typically less than that of what you would expect a stock portfolio to earn over the long run. For someone looking to limit their risk, or willing to accept lower returns in exchange for certain guarantees however, they can still be a beneficial part of a good retirement plan.