Fixed Annuities Pros and Cons: Are They Right For Your Retirement Plan?

Fixed Annuities Pros and Cons

According to Investopedia, fixed annuities are financial products that offer growth without market risk. They are offered by licensed and regulated insurance companies. And they offer the owner of the annuity a choice between a set amount of income paid at regular intervals or tax-deferred growth of a lump sum of money.

  • A life annuity pays a predetermined amount each period until the death of the annuitant.
  • A term certain annuity pays a predetermined amount each period, usually monthly, until the product expires.

Before we get into the “when to use/not use an annuity” discussion, let’s briefly digress.

There is a time and place to use each and every financial product out there. When to use them is a matter of understanding where they fit.

Annuities are no different. There are certain situations where they’ll work well and others not so well. Plus, you’ll need to take into account the different types of annuities such as fixed, indexed, variable, single premium immediate, etc. Each perform well in certain situations.

We will limit ourselves to deferred fixed annuities for the purpose of this discussion. Deferred fixed annuities will provide a guaranteed rate of return over a period of time, similar to a CD. The rate of return usually mimics current interest rates and is often higher. What could ever be bad about that?

Fixed Annuities versus Certificates of Deposits (CDs)

A certificate of deposit (CD) is a product offered by banks and credit unions that provides an interest rate premium in exchange for the customer agreeing to leave a lump-sum deposit untouched for a predetermined period of time.

If you compare a five-year fixed annuity paying 3.5 percent to a five-year CD paying 2.5 percent, it looks like a great deal. That’s until you uncover the surrender penalty. The surrender penalty is the amount you pay if you need to pull the money out before the end of the five years.

While fixed annuities typically have higher rates of return, they also have higher surrender penalties than CDs. For example, the fixed annuity may have a surrender penalty of ten percent and dips into principal while the CD may just penalize you with a couple months interest. Therefore, before making a decision about which is better. You need to think about your personal situation.

You need to analyze different life scenarios that could happen over the five years. Is there a high probability that you may need to pull that money out and use if for something else? If so, the fixed annuity is probably not the best option due to the surrender penalty.

Additionally, interest rates right now are relatively low. Fixed annuities aren’t currently favorable because their rates of return follow along with interest rates. But as soon as interest rates start to rise again, fixed annuities will become a much more viable financial product.

Benefits of fixed annuities

  • You receive regular payments that provide supplemental income during your retirement
  • Your contributions grow tax-deferred and only the interest gets taxed once you start receiving payments
  • You get a guaranteed rate of return not affected by market volatility

Disadvantages of fixed annuities

  • They have higher surrender penalties and fees than other investments
  • Guarantees are only as secure as the insurance company offering them
  • The funds and earnings withdrawn are taxed as ordinary income similar to a 401(k)

An annuity is one way to supplement your income in retirement. For some, this may be a good option. But for others, this may not be the best option due to the higher costs.

Remember, it’s all about the variables within your personal situation. Use this information as a guide, listen to our podcast and then do an analysis based on what will work best for you! And always consult an expert who can coach you, as needed.