An annuity is an interest based investment vehicle, that takes in a one time investment and yields a stream of steady income in return, throughout the annuity holder's life. Though annuities are not really insurance policies, these investment contracts may contain features like death benefits and minimum guarantees. We will start this article with the many different annuity types and later focus only on fixed annuities to give you in-depth information on the subject.
Annuity and its Types Explained
Let's understand annuity and its types.
- Immediate Annuities: As the name suggests, an immediate annuity entails immediate disbursements or distribution. Under an immediate annuity scheme, the receipts start immediately after the investment is made and this is beneficial for someone who's already retired.
- Life Insurance Annuity: These are types of lifetime annuities in which a contract between individuals and their insurance companies promise a lifelong income for a said initial payment.
- Deferred Annuities: Under this annuity, periodic payments are made towards the investment during an accumulation phase, and distributions only begin when this phase has concluded. This feature allows the holders to actually save for retirement over a period rather than coming up with all the money at once.
- Fixed Annuities: When an annuity pays up a fixed interest on the payments made during the accumulation period, it is termed as a fixed annuity. This feature makes them comparable with high-grade fixed income securities in their risk-return profiles.
- Variable Annuities: These usually come with a prospectus, as the credited return on them varies according to the portfolio's investment performance. They are the most suitable for risk tolerant people, who are looking for growth.
- Equity Indexed Annuities: When the credited interest of an annuity is linked or tied to the performance of an economic index, the annuity is termed as an indexed annuity. These are hybrid annuities, alternating between fixed and variable, even though they fall under the fixed annuity bracket.
- CD Annuities: The name comes from the fact that these feel and look like bank CDs from the outside. In actuality, CD annuities are medium to long-term investments where the fixed returns are in accordance with the interest rate stated and the term of the contract. They are good for conservative investors looking for a fixed, steady income.
Features of Fixed Annuities
No article explaining fixed annuities would be anywhere near complete without a detailed explanation of their salient features. So here they are.
- One Payment: Fixed annuities involve a single premium, i.e. they require only one payment. Any new payments into a fixed annuity are considered as new fixed annuities.
- Fixed Interest Rate: The reason they are so popular, is because they carry a fixed interest rate for the number of years the contract states. This translates into a guaranteed receipt for people who need regular income.
- Low Risk: The only way your fixed annuity can stop paying you any income, is if the firm goes kaput and your annuity amount exceeds the 'Annuity State Guarantee Limits'. Now there's a golden egg, if you need one.
- Steady Income: Fixed annuities yield a monthly fixed income, which is invaluable for retirees. Secure monthly checks can keep your household expenses sorted, even after you retire.
- Good Return on Investment: This no-risk investment gives a solid 3 to 10 percent return. Now beat that!
- Lifelong Income Generation: An annuity holder will be happy to know that his annuity receipts will most definitely outlive him. Just imagine, paychecks for life!
- Choice of Annuity Term: Annuities come in short, medium and long terms and give you freedom of choice to choose the one most suitable for you. The longer the annuity term, the higher the interest rate on your annuity.
- No Hidden Hassles: Fixed annuities come with no hassles related to micromanagement, contract signing, premium payments or paycheck receipts.
- A Life Insurance: Fixed annuities are like life insurance policies, for they come with the provision of death benefit for the remaining family members.
- No Upper Limit: There is no limit on the amount you wish to invest in a fixed annuity, nor is there a restriction on how many policies you should or can own. Choose your amounts and leave behind a healthy inheritance for your family.
- Hedging Against Inflation: Fixed annuities are good inflation hedges, as the amount you receive has some amount of interest included in it.
Fixed Annuity Performance
Let us move this article further, by looking at the performance of these annuities.
- Fixed annuities give a solid, guaranteed growth, as long as they are not prematurely terminated. Premature termination leaves you worse off, as compared to when it is allowed to reach maturity.
- Deferred fixed annuities earn substantially more than other money market instruments, like mutual funds and CDs, because of a compounded and totaled tax deferral.
After harping about the various benefits of fixed annuities, it is time to move on to some disadvantages and pitfalls.
- IRS Penalty of 10%: When anyone withdraws any income from a fixed annuity and he is below the age of 59.5, he is charged a 10% tax penalty by the IRS. It is good to note though, that this is just making less money, not losing money.
- Not a Capital Gain: Unless you are in a fairly low tax bracket, capital gains taxes are usually lower than ordinary income taxes. The problem with fixed annuities is that though growth is tax deferred, it is always taxed when it is received. It is taxed as ordinary income when received, rather than as capital gain.
- Penalty Charges on Withdrawal: The company providing fixed annuity usually has a clause in the contract, that imposes a penalty if the withdrawal amounts exceed the yearly allotment.
- Single Up Front Payment: No further money can be added to the same contract, even if you save up some more in the meantime. So if you've invested your savings into it, they will be subject to excess withdrawal fees.
- Contract Revelations: If you look at your annuity contract closely, it may not guarantee the same interest for the entire period. If you are not aware of this fact while investing, you could feel cheated, as most fixed annuities change their interest rate after a fixed number of years.
Fixed annuities are great market instruments for retirees or even for those who are extremely risk averse and conservative. But a healthy retirement plan should always be a healthy mix of various instruments, without tilting in favor of just one kind of investment. Do compare all the different kinds of annuities before you zero in on one. The trick to finding the best fixed annuity (translated to high paying) is to look for options when the market interest rates are high. Though a longer term will provide a higher yield, you will have to sacrifice some flexibility on your commitments.
Types of Fixed Annuities
There are three basic variations of a fixed annuity, namely the fixed immediate annuity, the fixed deferred annuity and the CD type annuity. While the immediate and deferred relate to the frequency of payments, the CD types are genuine hybrids. An immediate annuity yields payments immediately after the accumulation phase has ended (say after the 1 month of accumulation).
This is unlike the fixed deferred annuities, that actually reinvest the interest earned and pay out only at the end of the term in one lump sum payment. With immediate fixed annuities, larger investments give the highest monthly payments when invested for shorter terms. Deferred annuities act as piggy banks, for they accumulate investments over the accumulation period and pay off with a single large payout or a string of smaller monthly payouts, after a period of time. CD annuities not only guarantee a fixed interest payment, but they also give certain tax benefits.
The sooner you start your retirement planning, the more extravagant your retirement days can become. Imagine not having to ask anyone for a single penny, for your medical bills, for household expenses, not even for leisure. Get started with some annuity research right now, so you can find the annuity best suited for your particular needs and retirement goals. Have that holiday in Seychelles (yes, the one you've waited so long for), after you encash on your wise investment decisions. I hope my article helps you cash in on loads of fun.. there in Seychelles! I'd sure love to see some photos.