What Is a Fixed Annuity?

A fixed annuity is a type of insurance contract that promises to pay the buyer a specific, guaranteed interest rate on their contributions to the account. By contrast, a variable annuity pays interest that can fluctuate based on the performance of an investment portfolio chosen by the account's owner. Fixed annuities are often used in retirement planning.

How a Fixed Annuity Works

Investors can buy a fixed annuity with either a lump sum of money or a series of payments over time. The insurance company, in turn, guarantees that the account will earn a certain rate of interest. This period is known as the accumulation phase.

When the annuity owner, or annuitant, elects to begin receiving regular income from the annuity, the insurance company calculates those payments based on the amount of money in the account, the owner's age, how long the payments are to continue, and other factors. This begins the payout phase. The payout phase may continue for a specified number of years or for the rest of the owner's life.

During the accumulation phase, the account grows tax-deferred. Then the account holder annuitizes the contract, distributions are taxed based on an exclusion ratio. This is the ratio of the account holder's premium payments to the to the amount accumulated in the account that is based on gains from the interest earned during the accumulation phase. The premiums paid are excluded and the portion attributable to gains is taxed. This is often expressed as a percentage. This situation applies to non-qualified annuities, which are those not held in a qualified retirement plan. In the case of a qualified annuity, the entire payment would be subject to taxes.

Benefits of a Fixed Annuity

Owners of fixed annuities can benefit from these contracts in a variety of ways.

Predictable investment returns

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. The insurance company is then responsible for paying whatever rate it has promised in the annuity contract. This contrasts with variable annuities, where the annuity owner chooses the underlying investments and therefore assumes much of the investment risk.

Guaranteed minimum rates

Once the initial guarantee period in the contract expires, the insurer can adjust the rate based on a stated formula or on the yield it is earning on its investment portfolio. As a measure of protection against declining interest rates, fixed annuity contracts typically include a minimum rate guarantee.

Tax-deferred growth

Because a fixed annuity is a tax-qualified vehicle, its earnings grow and compound tax deferred; annuity owners are taxed only when they take money from the account, either through occasional withdrawals or as regular income.  This tax deferral can make a significant difference in how the account builds up over time, particularly for people in higher tax brackets. The same is true of qualified retirement accounts, such as IRAs and 401(k) plans, which also grow tax deferred.

Guaranteed income payments

Fixed annuities may be converted into an immediate annuity at any time the owner selects. The annuity will then generate a guaranteed income payout for a specified period of time or for the life of the annuitant.

Relative safety of principal

The life insurance company is responsible for the security of the money invested in the annuity and for fulfilling any promises made in the contract. Unlike most bank accounts, annuities are not federally insured. For that reason, buyers should only consider doing business with life insurance companies that earn high grades for financial strength from the major independent ratings agencies.

Criticisms of Fixed Annuities

Annuities, whether fixed or variable, are relatively illiquid. Fixed annuities typically allow for one withdrawal per year of up to 10% of the account value. This makes them inappropriate for money that an investor might need for a sudden financial emergency.

During the annuity's surrender period, which can run for as long as 15 years from the start of the contract, withdrawals of more than 10% are subject to a surrender charge imposed by the insurer. Annuity owners who are under age 59½ may also have to pay a 10% tax penalty, in addition to regular income taxes.

Finally, annuities often carry high fees, compared to other types of investments. Anyone interested in an annuity should make sure they understand all of the fees involved before they commit. It also pays to shop around because fees and other terms can vary widely from one insurer to the next.