Key takeaways
- A fixed annuity offers the security of predictable income but generally does not adjust for inflation, which could erode your purchasing power over time.
- Benefits include tax-deferred growth and insurance-like features such as death benefits. However, fixed annuities can be complex and carry high fees.
- Fixed annuities may suit those without other reliable income sources or who expect to live long lives, especially when paired with Social Security, but they should be balanced with growth-oriented investments to maintain long-term purchasing power.
A fixed annuity is one popular way to secure some income for retirement, with the main advantage being that the annuity guarantees you a certain amount of income. While some fixed annuities may pay income for the remainder of your life, others may pay out only over a certain period.
Here’s what you need to know about fixed annuities, their drawbacks and who should consider buying a fixed annuity.
How a fixed annuity works
An annuity is a contract with an insurance company that promises to pay a certain income over a period of time in exchange for money upfront. The annuity will pay out over some amount of time — say, 20 years — or until the death of the client, depending on how it is structured.
The appeal of an annuity is the relative safety of the income. The annuity may promise a guaranteed return on invested money or a minimum payout value. It may also offer other features such as a death benefit that functions like life insurance on the death of the client.
What makes an annuity a fixed annuity is how the payouts are structured. In this case, a fixed annuity promises a consistent monthly payout on the account, offering steady income for clients.
With a fixed annuity, clients can contribute money over their working lives or in one lump sum. They may take payments immediately, as in an immediate payment annuity, or they may take their payments later as part of a deferred annuity.
Other kinds of annuities such as variable annuities and indexed annuities offer other pros and cons. The potential risks and returns on all kinds of annuities can vary, so clients should understand exactly which kind they’re purchasing and how it’s structured.
The advantages of a fixed annuity
A fixed annuity has many of the same benefits as annuities in general, but it also offers unique benefits. The most prominent benefits of a fixed annuity are as follows:
- Tax-deferred gains
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Like all annuities, a fixed annuity can allow you to build wealth in a tax-deferred account. Earnings are not taxed until they’re withdrawn from the annuity, and if you contribute with after-tax money, any contributions to the account also come out without any taxes.
- No IRS contribution limits
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Annuities also allow you to contribute an unlimited amount of money, which can be a significant advantage for higher-income households, allowing them to maximize their funds’ tax-deferred growth. Annuities are not limited to the comparatively modest annual maximum contribution restrictions of a traditional 401(k) or traditional IRA, both of which offer similar tax-deferral benefits.
- Range of benefits
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Annuities can be structured to offer all kinds of insurance-like benefits — such as death benefits, survivor’s benefits, guaranteed minimum payouts and other provisions — to meet the needs of the buyer. They’re all factored into the price of the annuity.
- Secure monthly income
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Besides these pros, a fixed annuity offers the certainty of a monthly income over a specific time frame, potentially until death. The guaranteed income means that retirees can breathe a bit easier when they’re unable to work.
“As life expectancies increase, it is increasingly appealing to have income that will last for as long as you live,” says Chad Hamilton, CFP, senior vice president of practice management at Mariner Wealth Advisors in Tulsa.
The drawbacks of a fixed annuity
Despite their advantages, fixed annuities also present a number of drawbacks for investors, including:
- Complexity
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Annuity contracts can be dozens of pages long, with lots of important details written in legalese, making them difficult to understand. It’s critically important that you understand what rights and responsibilities you have under the contract.
- High fees
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Fees can be stacked onto your contract, such as sales commissions, which can run into the high single digits, percentage-wise. You may also be hit with other annual fees. Be sure to read your contract carefully.
- Illiquid
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Once you sign an annuity contract, it can be difficult or even impossible to get your money out again. You may have to cough up a surrender fee to wiggle out.
- Penalties for early withdrawal
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If you take your money out of the annuity contract before age 59½, you could be hit with early withdrawal penalties, lose the tax-deferral benefits of the annuity and even be subject to taxes on your gains.
- Counterparty risk
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Your annuity contract is only as good as the company you sign with, so any annuity exposes you to counterparty risk. Work with a strong annuity company to be sure that you get the income stream you signed on for.
- Exposure to inflation
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A fixed annuity guarantees you a certain income stream, but if inflation rises substantially, that money may buy a lot less than you’d hoped in 10, 15 or even 20 years. Plus, any money left at the end of the annuity will be worth less, too. That said, some annuity providers offer cost-of-living adjustment (COLA) riders to mitigate this risk. However, in some instances, the cost of these add-on features can outweigh their benefit.
“The downside of a fixed amount of income is that it cannot keep up with inflation and, therefore, you’ll want to make sure you have other investments with growth potential to complement this type of annuity,” says Hamilton.
Hamilton points out another drawback: Money paid in an annuity is no longer part of your estate. “For example, if you invest $250,000 into a fixed immediate annuity, that $250,000 is no longer available as an asset that you can pass on to your heirs,” he says. “It has been converted to an income stream that will (usually) end when you pass away. The exception is if there is a ‘period certain’ type of income benefit, which guarantees that the income will be paid out for a minimum number of years or has a joint life benefit that pays income to a spouse that outlives you.”
Who should consider a fixed annuity?
Fixed annuities can offer benefits, but they’re not for everyone, and prospective buyers should carefully consider the pros and cons.
Fixed annuities can be a good choice for risk-averse, hands-off investors looking for a guaranteed income in retirement, especially if they believe they may live a long life.
“Also, if you don’t have a monthly pension or any other monthly income source, it could be a good way to provide an amount of income that is not dependent on the markets or interest rates,” says Hamilton.
By matching a sizable fixed annuity with Social Security — which offers regular but growing payouts — retirees may be able to ensure they’ll have a stable base of income to live on. Of course, they’ll need to carefully plan based on what income they can expect from Social Security.
Still, you’ll probably want to avoid putting all your investment dollars in a fixed annuity because of the need for growth in your portfolio, especially if you expect to have a lengthy retirement. By maintaining at least some assets in a diversified stock portfolio, you’ll probably have a better chance at growth in later years, helping you to protect your purchasing power.
Fixed annuities vs. other annuities
A fixed annuity offers a set payout over a specific time frame and the safety of a guaranteed income. But a couple of other annuity types may address some of its shortfalls.
Fixed annuity vs. variable annuity
In contrast to a fixed annuity’s set payouts, a variable annuity gives policyholders the ability to earn larger payouts over time. Like its name suggests, a variable annuity makes a payout that depends on the performance of investments made in the annuity. Typically, policyholders would invest in subaccounts run by the insurance company, and the annuity’s monthly payout would rely on how the investments there performed.
The upside of a variable annuity is that you may end up with much more income than you would with a fixed annuity, depending on how aggressive the variable annuity is and how the market performs over your hold period. The downside is that you may not be guaranteed anything.
Fixed annuity vs. index annuity
Unlike a fixed annuity’s set payouts, an index annuity also gives the policyholder the ability to earn a larger payout over time. An index annuity tracks a stock index, such as the S&P 500, a collection of hundreds of America’s top companies, and then offers a payout that is some percentage of that index’s performance. An index annuity usually offers a minimum return, too.
The upside of an index annuity is that you may end up with much more income than in a fixed annuity, because your money is tied to growth-ier investments such as stocks. Of course, the underlying index could perform poorly, causing the index annuity to generate a minimum return that falls short of that of a fixed annuity.
Bottom line
Fixed annuities remain a popular type of annuity because of the relative certainty and security of the income they can provide late in life. However, like all annuities, fixed annuities come with some important drawbacks, so you must consider whether they meet your needs.
— Kim Husband contributed to an update of this article.
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