In the previous two sections, we covered the basic characteristics common to all annuity contracts. In this section we will explore fixed annuities and the features unique to them in more detail.
What Is a Fixed Annuity?
As its name implies, a fixed annuity is a type of contract that guarantees to return both the investor's principal plus a fixed rate of interest. These contracts essentially function much like Certificate of Deposits (CDs), except that they grow tax-deferred.
Safety of Principal
Fixed annuities are among the safest investments available, almost on a par with CDs. Although they are not backed by Federal Deposit Insurance Corporation (FDIC) insurance, fixed annuity carriers are required by state law to back their outstanding annuity contracts with cash reserves on a dollar-for-dollar basis. If an annuity carrier becomes bankrupt or insolvent for any reason, then reinsurance groups will step in and cover most or all of any investor losses. Although it has happened on occasion, it is extremely uncommon for investors to lose money in fixed annuities. However, investors who do get caught holding a contract with an insolvent company should be prepared to wait for a while to get their money back, just as bank customers at insolvent banks must wait to get their cash back from the FDIC.
The history of fixed annuities essentially mirrors the general history of annuities described in the introduction. All early annuities in any form were fixed annuities; they were the only kind of annuity that existed until 1952.
One of the chief benefits of fixed annuities is the rate of interest that they pay. Fixed annuity rates tend to be slightly higher than those of CDs, treasuries or savings bonds. This is because insurance carriers invest their clients' assets into a portfolio of long-term bonds and assume all of the naked risk from them, passing the majority of the earnings on to the contract holders. Many fixed contracts attempt to lure investors by offering an initial "teaser" rate that will eventually drop to a much lower rate for the duration of the contract. For example, a five-year fixed annuity could offer a first-year rate of 6%. However, the contract might only pay 3% for the remaining four years. Risk of Default and State Guaranty Associations
Investors who shop for the best fixed annuity rates should also take care to check each carrier's financial rating. Insurance companies are rated the same way as banks, stocks, bonds and mutual funds. The rating system varies depending upon the rating company, but the highest rating will be something like AAA or A++. Most investors should probably stick with insurance companies that have at least an A+ or equivalent rating. Although it is rare, insurance carriers can and do become insolvent on occasion. When this happens, state guaranty associations will step in and insure every annuity contract with the insolvent company up to a certain dollar limit, such as $100,000, $250,000 or more. However, investors should be prepared to wait for at least several weeks to get their money back, and in some cases it can take much longer. Each state guaranty association is also a member of the National Organization of Life and Health Insurance Guaranty Associations. Although virtually all life insurance companies are required by state law to join these associations in order to receive their protection, the public at large is largely unaware of their existence. This is because state laws forbid the use of this protection as a marketing incentive, unlike banks and credit unions which proudly display their federal insurance to their customers.
In Section 6, we will examine indexed annuities.
Introduction To Annuities: Indexed Annuities
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