Fixed Annuity

A fixed annuity is a financial product offered by insurance companies designed to provide an individual a steady stream of income in exchange for a lump sum payment or a series of premium payments. Its primary purpose is to provide a reliable source of income during retirement or for a specified period.

The importance of a fixed annuity lies in its ability to mitigate financial risk and offer peace of mind. It shields individuals from market volatility, ensuring that they receive a predetermined amount of money at regular intervals, regardless of economic fluctuations. This stability can be crucial for maintaining and achieving long-term financial security.

• A fixed annuity offers individuals a way to secure their financial future by ensuring a predictable cash flow, which can be essential for covering living expenses or achieving financial goals in retirement.
• The premium is protected from market fluctuations, offering peace of mind that your initial investment is safe. These are suitable for risk-averse individuals seeking financial stability as they provide a reliable source of income.
• It offers Tax-Deferred Growth. Earnings on premium grows tax-deferred, allowing money to compound more efficiently.
• While fixed annuities offer stability, they may have limitations, including lower returns than riskier investments and limited liquidity.

A fixed annuity is a financial contract between an individual and an insurance company that provides a guaranteed, predictable income stream. Let us look at how it works:

1. Purchase: An individual (annuitant) typically starts by making a lump-sum payment to the insurance company. This is called the "premium."
2. Accumulation Phase: After receiving the premium, the insurance company begins the "accumulation phase." During this phase, the insurance company invests the premium in its general portfolio, often in conservative, low-risk assets such as bonds. The earnings generated during this phase accumulate tax-deferred.
3. Annuitization: At a predetermined date chosen by the annuitant (usually at retirement), the annuity enters the "annuitization phase." This is when the fixed annuity starts paying out regular income to the annuitant.
4. Income Payments: The insurance company calculates the amount of income payments based on factors such as the premium amount, the annuitant's age, chosen payout options (e.g., single life, joint life, period-certain), and prevailing interest rates at the time of annuitization. The key feature of a fixed annuity is that the payout is guaranteed and does not depend on market performance.
5. Regular Payments: The annuitant receives regular income payments, typically every month, but other frequencies may be chosen.
6. Taxation: During the annuitization phase, the annuitant pays taxes only on the portion of each payment considered earnings, not the original premium. This tax treatment can provide tax advantages in retirement planning.
7. Death Benefit (optional): Some fixed annuities offer a death benefit option, which guarantees that if the annuitant passes away before receiving the full value of the annuity, the beneficiaries receive the remaining balance.

Fixed annuities come in several variations to meet investors' diverse needs and preferences. Here are some common types of fixed annuities:

1. Immediate Fixed Annuity: With an immediate fixed annuity, one makes a lump-sum payment to the insurance company, and the annuity starts providing regular income payments immediately, typically within one month. This option is suitable for retirees looking for an immediate income stream.
2. Deferred Fixed Annuity: A deferred fixed annuity allows one to invest a lump sum or make periodic premium payments over time. Income payments begin at a future date one selects, often at retirement. During the accumulation phase, the money grows tax-deferred.
3. Fixed Period Annuity: This annuity guarantees income payments for a specific period, such as 10, 15, or 20 years, regardless of lifespan. If one passes away before the period ends, the payments continue to your beneficiaries until the term concludes.
4. Fixed Lifetime Annuity: With a fixed lifetime annuity, one receives regular payments for the rest of your life, providing financial security and protection against outliving one’s savings. One can divide this type into single-life (payments stop at the annuitant's death) and joint-life (payments continue until spouses pass away) options.

Let us look at the following examples to understand the concept better:

Example #1

Imagine Sarah, a 60-year-old retiree, has saved $250,000 for her retirement. She's concerned about outliving her savings and wants a dependable source of income. Sarah decides to purchase a fixed annuity from an insurance company.

Sarah opts for a single premium immediate annuity (SPIA), paying the insurance company $250,000. In return, the insurance company guarantees her a fixed monthly payment for the rest of her life, no matter how long she lives. The insurance company offers her a 5% annual payout rate.

With her fixed annuity, Sarah receives $1,041.67 monthly ($250,000 * 5% / 12 months) for the rest of her life, providing her with a stable and predictable income stream. This income helps cover her living expenses, and she doesn't have to worry about market fluctuations impacting her retirement income.

Example #2

A survey report from LIMRA (Life Insurance Marketing and Research Association) points out that the fixed annuity sales in 2023, have witnessed a considerable increase from last year. There is a total of 101% increase to $70.9 billion in the first months of 2023, and LIMRA attributes the increase to several factors. These factors include equity market volatility, favorable interest rates, probability of recession etc.

The fixed-rate products have found a sudden attractiveness among people owing to the financial environment and hence the ongoing demand which will keep up its pace for a while according to LIMRA.

The taxation of fixed annuities in the United States varies depending on several factors, including the type of annuity, the timing of withdrawals or distributions, and individual tax circumstances. Key points to consider regarding the taxation of fixed annuities:

1. Tax-Deferred Growth: During the accumulation phase of an annuity, any interest or earnings on the premium are tax-deferred. Taxes on these gains are deferred until withdrawals or income payments commence.
2. Withdrawals Before Age 59½: Withdrawals before reaching the age of 59½ may be subject to a 10% early withdrawal penalty on the earnings portion, in addition to regular income taxes.
3. Income Tax on Withdrawals: Income payments from annuities are subject to ordinary income tax. This applies to the portion of each payment that represents earnings or interest. Premiums originally paid are not taxed because they were funded with after-tax dollars.
4. Annuity Payout Options: Annuities with life-contingent payouts may have a portion of each payment considered a return of the premium, not immediately subject to taxation. The remainder, representing interest or earnings, is taxable.
5. Death Benefit: If a fixed annuity includes a death benefit provision, the proceeds paid to beneficiaries upon the annuitant's death may be subject to income tax.

Here are the pros and cons of fixed annuities to understand the concept better:

Let us have a look at its pros:

1. Guaranteed Interest Rate: These annuities have a guaranteed interest rate, ensuring that the premium grows over time at a specified rate, often higher than a savings account.
2. Tax-Deferred Growth: During the accumulation phase, earnings on the premium are tax-deferred. It allows money to grow faster since taxes on gains aren't paid annually.
3. Death Benefit: Some annuities provide a death benefit. It ensures beneficiaries receive the remaining balance if the annuitant passes away before receiving the full value of the annuity.
4. Protection from Market Losses: Unlike variable annuities, fixed annuities are shielded from market fluctuations since the interest rate is guaranteed.

Let us have a look at its cons:

1. Limited Growth Potential: While the interest rate is guaranteed, it may not keep pace with inflation, potentially reducing purchasing power over time.
2. Lack of Liquidity: Fixed annuities are typically illiquid, making it challenging to access money without penalties, especially during the surrender period.
3. Surrender Charges: Significant withdrawals during the surrender period can incur surrender charges, reducing overall return.

Let us look at the comparison of fixed annuities and variable annuities:

Let us look at the comparison of fixed annuities and indexed annuities:

This article has been a guide to what is Fixed Annuity. We explain its pros & cons, compare it with variable and indexed annuities, examples, and taxation. You may also find some useful articles here -

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