Fixed annuities help stabilize income from investments and are most commonly used by people who are not fully participating in the workforce, are about to retire or have retired. Fixed annuities are insurance contracts that offer the annuitant - the person who owns the annuity - a set amount of income paid at regular intervals until a specified period has ended or event has occurred. There are advantages and disadvantages to purchasing a fixed annuity, and there are many types of options that, for a fee, can be added to a basic fixed annuity. Here we go over these different fixed annuities and their pros and cons.

SEE: A Tour Through Retirement Plans

Overview
Fixed annuities can be bought from insurance companies or financial institutions with a lump-sum payment (usually most of the annuitant's cash and cash equivalent savings), or they can be paid for on a periodic basis while the annuitant is working. The money that is invested in the annuity is guaranteed to earn a fixed rate of return throughout the accumulation phase of the annuity. During the annuitization phase, the money invested less payouts will continue to grow at this fixed rate. In some cases, however, annuitants don't live long enough to claim the full amount of their annuities. When this happens, they end up passing on the remainder of their annuity savings to the company that sold them the annuity. But whether the annuitant chooses to try to avoid this depends on the kind of policy s/he chooses.

When you are considering purchasing a fixed annuity, it is important to remember that you can often negotiate the price of these products. Also, the amount of money that an annuity will pay out varies (sometimes greatly) between financial intermediaries selling these products, so it's best to shop around and avoid making quick decisions.

SEE: Selecting The Payout On Your Annuity

Types of Fixed Annuities
The two main types of fixed annuities are life annuities and term certain annuities. Life annuities pay a predetermined amount each period until the death of the annuitant, and term certain annuities pay a predetermined amount each period (usually monthly) until the annuity product expires, which may very well be before the death of the annuitant.

Life Annuities
There are several kinds of life annuities, and they differ by the insurance components they offer the annuitant. That is, certain types of life annuities may alter the future payment structure in the event of something negative happening to the annuitant, such as sickness or early death. More specifically, the more insurance components, the longer the payments may last over time once the annuitization phase begins (we look at how this works below) - and the longer the payments are to last, the smaller the monthly payments will be. The amount of the monthly payments also depends on the life expectancy of the annuitant: The lower the life expectancy, the higher the payment (because more of the annuity investment must be paid out over a shorter period).

Also, the prices of life annuities are composed of the money invested in the annuity but also the premium paid for these insurance components, so the more insurance components, the more expensive the annuity will be. Each type of life annuity has its own advantages and disadvantages, depending on the nature of the annuitant. Let's look at types of life annuities more closely.

Straight life annuities are the simplest form of life annuities - the insurance component is based on nothing but providing income until death. Once the annuitization phase begins, this annuity pays a set amount per period to the annuitant until s/he passes away. Because there is no other type of insurance component of this type of annuity, it is less expensive. Also, straight life annuities offer no form of payout to surviving beneficiaries after the annuitant's death. Those wishing to leave an estate to their survivors would be well advised to keep other investments if they are inclined to purchase a straight life annuity.

A substandard health annuity is a straight life annuity that may be purchased by someone with a serious health problem. These annuities are priced according to the chances of the annuitant's passing away in the near term. The lower the life expectancy, the more expensive the annuity because there is reduced chance for the insurance company to make a return on the money the annuitant invests into the annuity. For this reason, the annuitant of a substandard health annuity also receives a lower percentage of his or her original investment in the annuity. But because his or her life expectancy is lower, the payouts per period are substantially increased compared to the payments made to any annuitant who is expected to live for many years. Other insurance components are generally not offered with these vehicles.

Life annuities with a guaranteed term offer more of an insurance component than straight life annuities by allowing the annuitant to designate a beneficiary. So if the annuitant passes away before a period of time (the term) has passed, the beneficiary will receive the sum of the money not paid out. So in the event of an earlier-than-expected death, annuitants do not forfeit their annuity savings to an insurance company. Of course, this advantage comes at an additional cost.

Another thing to remember with life annuities with a guaranteed term is that in the event of unexpected death, beneficiaries receive one lump-sum payment from the insurance company. The likely result of such a payout is a spike in the annual income of the beneficiaries, and an increase in income taxes in the year they receive the payment. These tax implications can result in the annuitant leaving less to his or her designated beneficiaries than intended.

A joint life with last survivor annuity continues payments to the annuitant's spouse after the annuitant's death. The payments are passed on no matter what (i.e. don't depend on whether the annuitant dies before a certain term). These annuities also provide the annuitant the chance to designate additional beneficiaries to receive payments in the event of the spouse's sooner-than-expected death. Annuitants may state that beneficiaries are to receive lower payments.

The advantages of a joint life with last survivor annuity is that the annuitant's spouse has the security of continued income after the annuitant's passing, but because the payments are periodic rather than lump sum, the spouse will not be left with unnecessary tax burdens. The disadvantage here is cost. As these contain more of an added insurance component, the costs to annuitants are substantially higher.

SEE: Life Expectancy: It's More Than Just A Number

Term Certain Annuities
These annuities are a very different product than life annuities. Term certain annuities pay a given amount per period up to a specified date, no matter what happens to the annuitant over the course of the term. However, if the annuitant dies before the specified date, the insurance company keeps the remainder of the annuity's value.

These contain no added insurance components; that is, unlike the life annuities discussed above, the term certain annuities do not account for the annuitant's condition, life expectancy or beneficiary. Further, in the event of failing health and increased medical costs, the income of a term certain annuity will not increase to accommodate the annuitant's increased expenses. Because these annuities offer less insurance options and therefore pose no risk to the insurer or financial-services provider, they are substantially less expensive than life annuities.

The disadvantage of these income vehicles is that once the term ends, income from the annuity is finished. Often, term certain annuities are sold to people who are looking for stable income for their retirements but who are not interested in buying any sort of insurance component or cannot afford it.

Registered and Unregistered Annuities
For all fixed annuities, the growth of the money invested is tax deferred, but annuities can be purchased with pretax income and be tax deferred, or they may be purchased with money that has already been taxed. The type of income (pretax or after-tax) with which an annuity is purchased determines whether it qualifies for tax-deferred status.

Those annuities purchased with pretax income qualify for tax-deferred status as the money invested in them has never been taxed. Qualifying annuities are purchased at retirement with funds that have been invested in a qualified retirement plan and have grown tax free. Qualifying annuities can also be bought periodically over the working life of the annuitant with money that is not yet taxed. Annuities that are purchased with money that has already been taxed at the income source do not qualify for tax-deferred status. These are usually purchased at retirement or during the working life of the annuitant.

The advantage of a qualified annuity is tax-free growth on invested money, and tax is deferred until the money is paid out. The advantage of an unqualified annuity is tax-deferred growth on the income made from taxed money invested in the annuity.

In the case of either qualified or unqualified annuities, when the annuitant passes away, the beneficiary will owe very high taxes on the investment income. Beneficiaries do not enjoy tax-free status on annuities received. When annuitants are estate planning, it is important they consult with a specialist or do careful research to ensure that their loved ones are not being left with a tremendous tax burden.

The Bottom Line
Fixed annuities are a powerful vehicle for saving for retirement and guaranteeing regular streams of income upon retirement. They are often used for tax deferral and savings. At the same time, annuities can be very tricky to manage for maximum returns since the cost of insurance features can eat into the return you get on your initial investment. Annuity contracts are complicated, and those who don't understand them may end up paying a a great deal of money for an instrument that doesn't serve its intended purpose. To reap the benefits of reduced taxes, stabilized returns and the invaluable peace of mind that fixed annuities can offer, investors need to thoroughly research and consider these instruments against other retirement income such as pension payouts and other IRAs.

Related Articles
  1. Retirement

    Best Ways to Save For Retirement Without an IRA or 401(k)

    Learn the most common types of savings vehicles used to accumulate money for retirement outside employer-sponsored 401(k)s or IRA accounts.
  2. Professionals

    How to Buy Annuities When Interest Rates Are Low

    The current low interest rate environment complicates the decision to buy an annuity. Here's what financial advisors need to consider for their clients.
  3. Professionals

    Top Retirement Prep Questions to Ask Clients

    Is your client really ready for retirement? Here are some essential questions to ask.
  4. Stock Analysis

    How MetLife Became a Global Insurance Giant

    MetLife is the largest life insurer in the United States. Here's how it has managed to stay on top.
  5. Investing

    Advising FAs: Explaining Annuities to a Client

    Conceptually speaking, annuities can be thought of as a reverse form of life insurance.
  6. Professionals

    Is Your Financial Advisor Looking Out for You?

    Financial advisors sometimes aren't looking out for clients' best interests. Regulators are scrutinizing their practices; investors should too.
  7. Fundamental Analysis

    Present Value Interest Factor of Annuity (PVIFA)

    PVIFA can be used to calculate the present value of a series of annuities by considering cash flows and depreciation.
  8. Investing Basics

    Top 3 Ways to Manage Lump-Sum Windfalls

    Have you just had a load of money drop into your lap? If so, several enviable options are available to you. Which one is the best choice?
  9. Retirement

    Understanding Regulations on Qualified Longevity Annuity Contracts

    QLACs provide retirees a way to guarantee a lifetime income – as long as the regulations set out by the IRS are followed. Here's an overview.
  10. Retirement

    A Guide to Qualified Longevity Annuity Contracts

    QLACs are one way to make sure you don't outlive your retirement savings. Here's how they work.
RELATED TERMS
  1. Qualified Longevity Annuity Contract

    A Qualified Longevity Annuity Contract (QLAC) is a deferred annuity ...
  2. Contingent Annuitant

    Someone designated by an annuitant to receive the annuitant’s ...
  3. Living and Death Benefit Riders

    Living and death benefit riders are a descriptive class of contractual ...
  4. Annuity

    A financial product that pays out a fixed stream of payments ...
  5. Next Generation Fixed Income (NGFI) ...

    A Next Generation Fixed Income (NGFI) manager is a fixed income ...
  6. Subaccount Charge

    Fees charged for the management of an investment fund.
RELATED FAQS
  1. What are the best ways to sell an annuity?

    The best ways to sell an annuity are to locate buyers from insurance agents or companies that specialize in connecting buyers ... Read Full Answer >>
  2. How are non-qualified variable annuities taxed?

    Non-qualified variable annuities are tax-deferred investment vehicles with a unique tax structure. After-tax money is deposited ... Read Full Answer >>
  3. Can a variable annuity be rolled into an IRA?

    You can roll qualified variable annuities, such as other qualified retirement plan accounts, into a traditional IRA. Non-qualified ... Read Full Answer >>
  4. Are variable annuities subject to required minimum distribution (RMD)?

    Variable annuities are insurance contracts that provide tax-deferred growth of assets that can later generate a guaranteed ... Read Full Answer >>
  5. For what types of financial instruments would I want to calculate the present value ...

    Because the present value of an annuity formula relies on a consistent interest rate and identical payments for a set period ... Read Full Answer >>
  6. What exact information is included in the interest rate when calculating the present ...

    When calculating the present value of an annuity, the interest rate percentage is the rate at which future payments are discounted ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!