What is a fixed annuity and how does it work?

A fixed annuity is a tax-advantaged retirement savings option that can help to help build predictable assets while you're working. Then, after you decide to retire, it can create a guaranteed stream of income that could last for the rest of your life. If those benefits appeal to you, read on to find out more about:

• How fixed annuities work

• Benefits and drawbacks

• How fixed annuities compare to other types of annuities

What is a fixed annuity?

A fixed annuity is a contract with an insurance company that is similar in many ways to a bank certificate of deposit. You pay one or more premiums to build up the account balance, and the insurer provides a guaranteed rate of return on that principal. Typically, the rate of return is guaranteed for multiple years, such as five years. After the initial guaranteed period, the insurer will reset the interest rate at regular intervals – usually annually – but the new rate cannot be lower than the guaranteed minimum interest rate in the contract.

How fixed annuities work

All annuities work on the same basic principle. You pay one or more premiums to an insurance company that invests the money to generate returns, which generally grow tax-deferred. When you decide to take income in retirement, the insurance company uses those funds to make regular payments to you for the period of time specified in the annuity contract (e.g., 10 or 20 years) – or over your lifetime.

A fixed annuity (also called a fixed deferred annuity) starts off as a savings vehicle, and you can make contributions either as a lump-sum payment or as a series of contributions. This period of time — before you start taking income — is known as the accumulation phase.

The distribution phase starts when you decide to start making withdrawals, usually at retirement (and there can be tax consequences to withdrawing funds from an annuity before age 59 ½). If you bought the annuity with pre-tax dollars, withdrawals will generally be taxed as ordinary income – but if you are retired or working less at the point, you’ll likely be in a lower tax bracket. If you purchase the annuity with after-tax dollars, you typically only owe taxes on interest earned.

Payout options

You don’t necessarily have to convert a fixed annuity into regular income payments in retirement. In most cases, you can choose not to annuitize and receive the entire value of the annuity in one lump-sum payment. Fixed annuity contracts and terms vary by provider, but other payout options typically include:

• Period certain: You receive regular (e.g., monthly or quarterly) guaranteed payments for a fixed period of time, such as 10 or 20 years. If you pass away during that period, payments continue to your beneficiary.

• Single life: This option provides regular income payments for as long as you live. However, once you pass away, the payments stop, regardless of the remaining balance in your annuity account. However, many annuities include a death benefit rider that will pass on at least a portion of any remaining balance to your beneficiaries.

• Joint and survivor: This annuity covers two individuals, typically spouses, and continues to generate payments as long as one of you is alive. After one person passes away, the surviving spouse continues to receive payments until they pass away. Periodic payments in these annuities are typically lower than for a single life annuity because the insurance company will likely have to continue paying income for a longer period of time.

Benefits of fixed annuities

There are many reasons why people choose these annuities, including:

• Dependability: Along with the guaranteed fixed interest rate, your principal (the money you paid to buy the annuity) will stay intact unless you withdraw or decide to end the contract early.

• Tax-deferred growth: The interest you earn during the life of your annuity grows tax-deferred, which means you don’t pay taxes on the interest until you withdraw it. This may provide a tax advantage, especially if you begin to make withdrawals when you’re in a lower tax bracket.

• Compounded growth: All interest that remains in the annuity also earns interest. This is called “compound” interest. This growth can continue for as long as you hold your annuity (subject to age limits).

• Guaranteed income: After the first year, you can convert the amount in the annuity into a guaranteed stream of fixed income for a specified period of time — or even for the rest of your life if you choose.

• Flexible withdrawals: You may withdraw the money in your annuity at any time as a single withdrawal, or through scheduled income payments. However, providers may add charges for certain early withdrawals, and there can be tax consequences before age 59 ½. Once your annuity payments have begun, there is no flexibility to make changes.

Potential downsides of fixed annuities

While fixed annuities can offer stability and predictable income, there are potential downsides to consider.

• Limited Growth Potential: Fixed annuities often have lower return rates than other investments like stocks or mutual funds, limiting growth potential for your retirement savings. Also, if interest rates rise after you purchase a fixed annuity, the rate you lock in might result in comparatively lower returns.

• Inflation Risk: The fixed income from an annuity may not keep up with inflation, potentially eroding purchasing power over time.

• Liquidity Issues: Early withdrawal from an annuity can come with hefty penalties and surrender charges, reducing access to funds for unexpected needs.

How they compare to other types of annuities

• Fixed vs. variable annuities: The primary difference between fixed and variable annuities lies in how the principal grows. A fixed annuity contract provides guaranteed fixed interest rates, and there is no investment risk, i.e., you know what your return will be. A variable annuity can allow for greater potential growth by investing in securities similar to mutual funds, but you bear the investment risk and potential for losses. That can lower your income payments when you need money in retirement; conversely, if your investments do well, you could have larger income payments.

• Fixed vs. fixed index annuities: Fixed index occupy a middle-ground between fixed and variable annuities, offering a blend of risk protection and market-based growth potential. Unlike a fixed annuity that provides a guaranteed interest rate, a fixed indexed annuity is tied to a broad market index. Your returns are based on the performance of this index, subject to a cap and a floor. This means gains are limited to a maximum percentage, and losses are prevented from falling below a certain level, protecting the principal investment. This can provide an attractive balance for those seeking moderate growth without the higher risk profile of a variable annuity.

• Immediate annuities: Unlike fixed annuities that start with an accumulation phase, immediate annuities begin income payments almost immediately after the initial investment (or within a year at most). Also called an immediate income annuity, it is often selected by retirees who have already built up their retirement savings are seeking a reliable way to generate regular income – like a paycheck or pension payment – that begins right away.

Things to consider before buying a fixed annuity

A fixed annuity could be a good option to supplement your IRA or 401(k) funds and create a guaranteed stream of income in retirement, especially for those who want to lower their exposure to investment risk. If you think a fixed annuity might be the right option for you, here are some things to think about.

How long do you want income payments to last?

Annuities can provide regular, predictable income for a set number of years — or the rest of your life. However, generally speaking, the longer you want payments to last, the lower the amount of each payment. Also, adding a death benefit to a lifetime annuity will result in somewhat lower payments.

• Death benefits: It's important to consider what will happen to the money in your fixed annuity if you pass away while there's still a balance in your account. A death benefit feature allows you to designate a beneficiary who will receive a specified amount upon your death, either as a lump sum or in the form of continued payments. This can typically be the remaining value in the annuity account or a guaranteed minimum amount, depending on the terms of the contract. Always review the specific annuity contract terms and consult with a financial professional to understand the implications and taxes that may affect your beneficiary.

• Qualified vs. non-qualified annuities: You can pay for an annuity with pre-tax or post-tax dollars (i.e., income that has already been taxed) depending on your needs. Either way, investment earnings in the annuity grow tax-deferred, but your money is taxed differently as you put funds into the annuity and take payments out.

  • Qualified annuities are funded with pre-tax dollars, typically through retirement plans like a 401(k) or IRA. Premium contributions aren't considered taxable income for the year they are paid, but when you take income in the distribution phase, the entire amount is typically subject to taxes.

  • Nonqualified annuities are funded with after-tax dollars, so taxes have already been paid on the contributions. When you take income in the distribution phase, only the investment earnings are subject to taxes.

• Surrender charges and fees: Annuities are not considered liquid investments and typically come with restrictions and penalties for early withdrawal. Be sure to ask about “surrender charges” – fees imposed by an insurance company for withdrawing funds from an annuity contract prematurely. Also, in most cases, a 10% penalty is imposed by the IRS if you withdraw funds before the age of 59 ½.

• Insurance provider integrity: A fixed annuity is a contract between you and an insurance company to provide guaranteed payments designed to last for several years – or the rest of your life. But the guarantees of an annuity are only as strong as the claims paying ability of the company behind it. Look at the insurance company’s financial strength ratings(FSRs): Independent rating agencies are responsible for gauging the financial strength of companies, and exemplary ratings indicate that a company can honor its financial commitments and pay its claims.

Why people choose fixed annuities from Guardian

An annuity can be an important part of your financial strategy, along with life insurance and other investments. No matter where you are in your retirement planning — or how much you need to save for other life goals — Guardian can help provide guidance to help you retire the way you want and explain different annuity options.

For example, the Guardian Fixed Target Annuity SM offers a guaranteed rate of return for three-to-ten year periods (all may not be available at all times). You can select the time period that best fits your retirement time frame. We can connect you with a local financial professional who can explain your options for all types of annuities, review the available tax benefits, and help you decide what makes sense for you.