Due, in large part, to stock market volatility and the continued uncertainty of the economy, annuity sales are seeing resurgence as more people shift towards a “capital preservation” mentality. A good portion of the outflows from stock and bond mutual funds have been finding their way into fixed annuities as havens from the chaos and unpredictability of the financial markets. Many people are looking at fixed annuities for the first time, so this explanation of how they work is very timely.

Fixed Annuities from the Inside

Fixed annuities are often compared to bank CDs if only because they both offer a fixed yield with the promise of safety of principal. Fixed annuities are quite a bit different than CDs in just about all aspects including how they generate their fixed rate and how they protect your principal.
Fixed annuities are contracts issued by life insurance companies to individuals looking for guaranteed rates of return without any risk to principal. Because they are, in essence, insurance contracts, they enjoy some of the same tax benefits of life insurance policies, such as tax deferred growth of earnings. Taxes are eventually paid when the earnings are withdrawn.

Competitive Fixed Yields

The rates on fixed annuities are derived from the yield that the life insurance company generates from its investment portfolio which is invested primarily in high quality corporate and government bonds. A portion of its yield is credited to the annuity account as a guaranteed fixed rate. You can select a guarantee period from one year to 10 years, with the longer periods typically credited with higher rates. Many fixed annuities offer a premium bonus for larger deposits of $50,000 or $100,000. The bonus rate, which could be an additional percentage point, is usually paid on the first year of the deposit.

Guaranteed Minimum Rates

Once the initial guarantee period expires, the rate is adjusted based on a specified formula, or the prevailing yield earned in the insurer’s investment account. As a measure of protection against declining interest rates, fixed annuity contracts include a minimum rate guarantee.

Tax Deferred Growth

We did mention the tax deferral aspect of fixed annuities, which, for people in the higher tax brackets, can make a significant difference in the amount accumulated over time. If an investor who pays taxes at a combined state and federal rate of 50% invests in a fixed annuity with a 4% yield, he or she would have to find a bank CD paying 6% to generate the same net return. When the earnings are withdrawn or taken as income, they are taxed as ordinary income.

Withdrawals

To receive the maximum benefits that tax deferral provides, investors should be willing to commit their funds for the long term. But, because things do come up, annuity funds are accessible through annual withdrawals that can be made without charge as long as they don’t exceed 10% of the account balance. Most fixed annuities are structured with a surrender period in which a fee will be charged on excess withdrawals. The surrender periods generally last for seven to 12 years, and the fees, which can start as high as 12% decline each year until they vanish, after which funds are completely accessible without restriction. Any withdrawals made prior to the age of 59 ½ may be subject to an IRS penalty of 10%.

Guaranteed Income Payments

Withdrawals are one way to access annuity funds. Additionally, fixed annuities may be converted to an income annuity at any time. When this happens, the funds are irrevocably committed to the life insurer who promises to make a series of period payments for a specified period of time, or for the life of the annuitant.
If someone wanted to defer taxes further into the future, they could specify a period certain, such as five years, for annuity payments. Because each payment consists of both a return of principal and interest earned they are only partially taxed. Taxes will only be paid on the interest portion as they are received. Otherwise they could elect to receive annuity payments for life, which means that the life insurer is obligated to make payments for as long as the annuitant lives.

Safety of Principal

Fixed annuities are considered to be one of the safest investments available. The principal is backed by the assets of a life insurance company which must meet very stringent reserve requirements and financial standards. Unlike a bank, which only maintains a small fraction of its obligations in reserve, life insurance companies are required to maintain as much as 90% of their obligations as liquid reserves. Life insurers that meet the highest standards of financial integrity and strength are assigned the highest ratings by the independent rating agencies, such as A.M. Best, Standard & Poor’s and Moody’s. These companies can be expected to perform well and meet all of their obligations even in the worst of economic conditions.

Fixed Annuities as an Investment

For money that is looking for stability, predictability, and security, fixed annuities are ideal. Investors with a 10 to 20 year time horizon, who are risk adverse, or who want to begin allocating more of their assets towards capital preservation, would find annuities highly suitable.
While fixed annuities can help investors guard against market risk and taxation, they should really be considered as part of an overall investment strategy that includes some growth oriented investments. The risk of putting all of your eggs into the fixed annuity basket is that the rate of growth of fixed yields may not be sufficient to outpace the rate of inflation which can erode the value of your investment over time.
When included as part of an asset allocation strategy, fixed annuities can provide the portfolio with stability and predictability which should allow investors to take a little bit more risk with other parts of the portfolio.

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