Helping to stabilize income from investments, fixed annuities are most commonly used by people who are not fully participating in the workforce, are about to retire or have already 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 an event (like the annuitant's death) 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 the basic product.
How Do Fixed Annuities Work?
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 (when money is being put into it).
During the annuitization phase (when money is being paid out), the balance invested, minus 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 the remainder of their annuity savings to the company that sold it to them. But whether the annuitant chooses to try to avoid this depends on the kind of policy purchased.
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) among the financial intermediaries selling these products, so it’s best to shop around and avoid making quick decisions.
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, while 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.
Different Types of Life Annuities
There are several kinds of life annuities, and they differ by the insurance components they offer. 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 there are, 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 they 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 both the money invested in the annuity and the premium paid for these insurance components. Therefore, the more insurance components you have, the more expensive your 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 the various types of life annuities more closely.
Straight Life Annuities
These 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 until the annuitant dies. Because there is no other type of insurance component to 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.
Substandard Health Annuities
These are straight life annuities that may be purchased by someone with a serious health problem. They are priced according to the chances of the annuitant dying in the near term. The lower the life expectancy, the more expensive the annuity, because there is less of a chance for the insurance company to make a return on the money the annuitant invests.
For this reason the annuitant of a substandard health annuity also receives a lower percentage of his or her original investment in the annuity. However, because life expectancy is lower, the payouts per period are substantially increased compared with 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
Life annuities with a guaranteed term offer more of an insurance component than straight life annuities by allowing the annuitant to designate a beneficiary. If the annuitant dies before a period of time (the term) has passed, the beneficiary will receive whatever sum has not been paid out. In the event of an earlier-than-expected death, however, annuitants do not forfeit their savings to an insurance company. Of course, this advantage comes at an additional cost.
Another thing to remember: 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 in which they receive the payment. These tax implications can result in the annuitant leaving less to his or her designated beneficiaries than intended.
Joint Life with Survivor Annuity
These continue payments to the annuitant’s spouse after his or her death. The payments are passed on no matter what (that is, they 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.
Different Types of 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. 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, 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 expenses, the income of a term certain annuity will not increase to accommodate the annuitant’s increased costs. Because these annuities offer fewer 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. Term certain annuities are often sold to people who want stable income for their retirement but are not interested in buying any sort of insurance component or cannot afford one.
Qualified and Unqualified Annuities
For all fixed annuities, the growth of the money invested is tax-deferred, but annuities themselves can be purchased with pretax income, 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 because the money invested in them has never been taxed. Qualified annuities are purchased at retirement with funds that have been invested in a qualified retirement plan, such as a 401(k), and have grown tax-free.
Qualified 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 they inherit. When annuitants are doing their estate planning, it is important to 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 during it. They are often used for tax deferral and savings. At the same time, annuities can be very tricky to manage for maximum returns, as the cost of insurance features can eat into the return on the 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 sources, such as pension payouts, 401(k)s and IRAs.