Fixed Annuity

What it is:

A fixed annuity offers a fixed rate of return, and all its future payments are equal amounts.

How it works/Example:

Assume you'd like to invest in a vehicle that will provide you with guaranteed monthly payments of $1,167 every month for as long as you live after you retire. The insurance company selling this annuity to you might require, say $175,000, now to obtain this guaranteed future stream of income.

What makes an annuity fixed is that the insurance company promises that your money will earn a predetermined, fixed return per year for as long as you live. If the fixed annuity is at 8%, for example, the $175,000 earns 8% per year no matter what, and when it comes time to start receiving your $1,167 per month, the insurance company is obligated to pay 8% on the money remaining in the account.

There are two kinds of fixed annuities: life annuities and term certain annuities.

  • Life annuities make payments to the investor for as long as the owner lives, and the insurance company keeps whatever is left when the owner dies. Some life annuities allow the owner to purchase a guaranteed term, meaning that if the owner dies before the a certain date, the owner's beneficiary receives the rest of the annuity payments (usually a lump sum, which usually entails a steep tax bill for the beneficiary).
  • Term certain annuities make payments to the investor for a set period of time, which could end while the owner is still alive. If the owner dies before the term expires, however, the insurance company usually gets to keep the remainder of the payments.

Why it Matters:

The insurance company uses the money an investor pays for an annuity to generate the investor's annuity payments later. If the insurance company invests this money wisely, it can earn more on the money than it has to pay out to the owner of the annuity and thus turn a profit. If, on the other hand, it invests the money poorly, the insurance company will have to look to other sources of cash to meet its obligation to the annuity owner.

This is an important concept, because owners of fixed annuities essentially relegate the investment decisions to the insurance company and thus agree to forgo any returns above what the insurance company has promised to pay. So if the investor is guaranteed 8% per year but the market is returning 12%, this may not be such a good deal for the investor. Fixed annuities also offer little inflation protection, because their payments stay the same over time. On the other hand, getting a guaranteed return means the size of the investor's monthly annuity income will not suffer from his own bad investing decisions or from market downturns. Thus, fixed annuities are often most attractive to investors who prefer to relinquish control, are not in a high tax bracket, will need income for years to come, and don't need to provide something for their heirs.

There are some general characteristics common to most annuities that investors should also consider before investing. Notably, the interest, dividends and capital gains earned on an annuity’s underlying investments are tax-deferred until withdrawal, and then they are taxed at the ordinary income tax rate (this means there is usually no additional benefit from holding annuities in IRAs or other tax-advantaged accounts). Also, an annuity can lose some or all of its value if the issuer goes bankrupt. Therefore, the creditworthiness of an issuer is important.

Fees are also major sources of controversy for annuities. There are often front-end loads, state taxes and annual fees based on a percentage of the account value, early withdrawal penalties, etc., and they may offset much or all of an annuity’s tax advantages. Pressuring sales tactics and less-than-transparent disclosure have also tarnished the image of annuities, so investors should read these disclosure materials and ask his or her financial consultant plenty of questions.

Best execution refers to the imperative that a broker, market maker, or other agent acting on behalf of an investor is obligated to execute the investor's order in a way that is most advantageous to the investor rather than the agent.