What is a Fixed Annuity?

Highlights:

• A fixed annuity is a special kind of investment option, backed by an insurance company, that can provide investors with a guaranteed stream of income during retirement.
• Unlike other types of annuities, fixed annuities offer a guaranteed minimum payout and a fixed interest rate, making them a great choice for risk-averse investors.
• Fixed annuities are not completely risk-free. They offer little to no protection against inflation and are likely to be more expensive than other retirement savings options.

Fixed annuities trade present-day payments for guaranteed minimum payouts in the future. They can be a great option for investors looking to supplement their monthly retirement income. But like all investments, fixed annuities come with risks as well as rewards.

Before you commit to a fixed annuity, learn what they do — and don't — offer.

How do fixed annuities work?

A fixed annuity is a special kind of investment option, backed by an insurance company, that provides a guaranteed stream of income after a certain period of time. Fixed and other types of annuities are offered by insurance companies, banks and other financial institutions, often as a retirement-planning tool.

After signing a fixed annuity contract, you'll contribute money in either a large lump sum or smaller monthly payments called premiums. Contributions then grow on a tax-deferred basis over a set period of time called the accumulation phase. Earnings that accumulate are also tax-deferred and are not treated as taxable income until they are withdrawn.

When the accumulation phase ends, you enter the distribution phase. During this time, the company holding the annuity distributes regular payments to you. Payment size depends on multiple factors, including the type of annuity you select and the amount you've contributed over time.

With a fixed annuity, you'll lock in an interest rate and receive guaranteed minimum payouts later in life, distributed in an amount that will be specified in your contract.

If you have an immediate fixed annuity, you'll typically begin collecting payouts within a year after you sign the contract. With a deferred fixed annuity, you'll have to wait longer to begin receiving payouts — generally until you reach retirement.

Pros of a fixed annuity

The benefits of a fixed annuity include:

• Tax-deferred gains. Fixed annuities grow tax-deferred. This means you won't owe taxes until you begin withdrawing funds. As a result, your money can gain more compound interest over time than it might in a regular savings account or certificate of deposit.
• Regular monthly income. Fixed annuities offer stable payouts that can supplement Social Security and retirement income. They can also provide a cushion if your savings and other assets run out, ensuring that you can still live comfortably in retirement.
• Reliable distributions. Unlike other annuity options, fixed annuities offer a guaranteed minimum payout and fixed interest rate. As a result, they are generally considered to be the most reliable type of annuity. You might earn more if the annuity company's investments do well, but you are always guaranteed at least your minimum payment.
• No contribution limits. Unlike a 401(k) or traditional IRA, fixed annuities have no contribution limits imposed by the Internal Revenue Service. The amount you pay in premiums is limited only by the terms of your contract.

Cons of a fixed annuity

The drawbacks of a fixed annuity include:

• No protection against inflation. Fixed annuities don't come with built-in protection against inflation. This can be a major downside given that annuities are generally long-term investments and inflation is a normal part of any long-term economic cycle. In some cases, you may be able to purchase a cost-of-living rider for your annuity that will help account for inflation. However, these riders are typically expensive.
• Surrender charges and tax penalties. Most fixed annuities include surrender periods — a length of time during which withdrawals trigger a fee called a surrender charge. Surrender periods can be quite long, and associated charges can total up to 20% of your contributions. If you withdraw funds before age 59½, you may also be subject to a tax penalty of 10% alongside the standard income tax.
• Limited liquidity. Because of surrender fees and other penalties, fixed annuities can be difficult to convert to cash. You're usually limited to an annual withdrawal of no more than 10% of your annuity's value. Given this limited liquidity, they will likely be inaccessible in the event of a financial emergency.
• High fees. In general, annuities may be more expensive than other investment options, and fixed annuities are no exception. You may face costly administrative fees, mortality expense risk charges and commission fees. Additionally, you may need to supplement your annuity with expensive riders that account for inflation or extend payments through the end of your life.

Why consider a fixed annuity?

If you can afford the associated costs, fixed annuities offer a low-risk way to supplement your future retirement income. The fixed interest rate and guaranteed minimum payout mean that fixed annuities are generally more reliable than other annuity options.

A fixed annuity may be especially helpful for individuals who are not yet ready for retirement. The longer you have before you retire, the more time your annuity contributions have to grow tax-deferred.

However, like any other investment, fixed annuities are not totally without risk. Always pay careful attention to the terms of your contract, including the surrender period and other actions and conditions that might trigger fees and penalties.