You may have heard that annuities can be a good way to generate income in retirement. But there are different types of annuities, and keeping the details straight can be confusing. In a series of three articles, we explain the features and benefits of the main categories of annuities – Fixed Annuities, Variable Annuities and Indexed Annuities.
All three types of annuities allow you to invest money, tax-deferred, to generate income in retirement. They all provide some type of guaranteed payments made at regular intervals for a specific number of years, or for the rest of your life. When you receive payments from an annuity, starting any time after age 59 ½, you pay taxes only on the portion that comes from investment income. That’s all true for each type of annuity. Beyond that, there are extremely important differences among them.
In Part 1 of this 3-part series, we describe Fixed Annuities. Part 2 discusses Variable Annuities, and Part 3 covers Indexed Annuities.
What is a fixed annuity?
So, all annuities generate payments for a specified term or for the rest of the annuity holder’s life. With a Fixed Annuity, those payments are the same, every time. Whether interest rates go up or down, or the stock market goes up or down, the payments from a Fixed Annuity remain the same. That’s why it’s called a fixed annuity – because the amount of the payment is fixed, unchangeable, set in stone.
How are the payments determined? The amount a fixed annuity pays depends upon a number of things. It’s quite logical, really – it’s mostly the terminology that makes things confusing. Here are the key features that affect fixed annuity payments:
- How much money you invest in the annuity – the more you invest, the larger the future payments will be. Unlike other types of retirement savings vehicles, such as 401(k) plans and IRAs, there is no limit on the amount you can invest in an annuity.
- The rate of return you earn on the money invested in the annuity – the higher the rate of return, the higher the future annuity payments. With a fixed annuity, the rate of return you can expect to earn is typically lower than what you might earn on variable annuities and indexed annuities. Why? Because the rate of return on a fixed annuity, which affects the size of your payments, is guaranteed, no matter what happens. Even if the stock market crashes, or the Fed lowers interest rates, or your bank pays 0% interest on your checking account, the return on your fixed annuity is guaranteed.
The return you will be able to lock-in when you buy a fixed annuity depends upon where interest rates are at the time. You shouldn’t expect to earn a very high rate of return if interest rates are low at the time. If you think you’d be better off waiting until interest rates rise, keep in mind that no one can predict when that will happen. Furthermore, if interest rates do go up, it typically means that inflation is rising, or is expected to rise. So, even though a higher rate of return on your annuity would mean higher payments later, your cost of living would be higher, due to inflation.
- How many years you wait for the payments to start – The longer you wait to start receiving payments, the more the money you invested in your annuity can grow, so the bigger your future payments will be.
- How many years you want the payments to last – the longer the annuity payments have to last, the smaller the payments will be. When you start withdrawing from your annuity, you’re taking back the money you invested upfront plus the return that money earned over time, in equal “installments”. If that total amount has to stretch out over a long period, the payments will be smaller than with an annuity that is set up to make payments for just a few years.
As mentioned earlier, you can choose to have your annuity payments last as long as you live. That is a great way to gain peace of mind if you are concerned about outliving your savings. Separately, when you die, some annuities will provide a benefit to your heirs, while others to not. Since it isn’t possible to predict how long you will live, an annuity that includes lifetime payments or a death benefit are more expensive than annuities that do not include these features.
Married couples can buy an annuity with payments that continue to the surviving spouse after the annuity holder dies, called a Joint Life with Survivor Annuity. Since there is more uncertainty about how long the annuity will have to last, a joint life with survivor annuity is also more expensive than a standard fixed annuity. That leads us to this important question: How much will the annuity cost? Insurance companies that sell annuities use all of the factors described above to determine how much it will cost to guarantee your fixed annuity payments. There is a math formula that is the backbone of annuity pricing, but unless you enjoy doing the math, the best thing to do is contact some insurance companies directly, or work with a reputable broker who can provide you with quotes from various companies, based on your needs.