Who Assumes the Risk With a Fixed Annuity?

A fixed annuity is a contract between an individual and an insurance company. It is designed to provide a guaranteed stream of income over a specific period, typically during retirement. The core appeal of fixed annuities lies in their predictability. They offer a set interest rate and periodic payments, shielding investors from market fluctuations. As a result, the insurance company assumes the majority of the risk associated with a fixed annuity. If you’re considering a fixed annuity or similar product, a financial advisor can help you determine if it’s a good fit for your retirement.

What Is a Fixed Annuity?

A fixed annuity is a type of insurance contract that offers the potential for a steady income throughout retirement and aims to safeguard against market volatility by offering the annuitant a specified interest rate on their contributions for a certain period.

An individual makes a lump sum payment or a series of payments to an insurance company. In return, the insurance company pledges to make periodic payments to the annuitant. The annuity can start immediately or be deferred to a later date, allowing the principal to grow over time.

One key advantage of fixed annuities is that they offer a fixed interest rate, providing a predictable income stream. This interest rate is determined by the insurance company and is outlined in the annuity contract.

Types of Fixed Annuities

Not all fixed annuities are structured the same way. Insurance companies offer several types of annuities that differ in how and when they pay interest, as well as when income begins. Traditional Fixed Annuities

These are the most straightforward contracts. They pay a guaranteed interest rate for a set period, typically ranging from one to 10 years. At the end of the guarantee period, you may be able to renew at a new rate, take a payout or convert the account into a stream of lifetime payments. This type appeals to those who want a predictable rate and are comfortable with renewing periodically.

Multi-Year Guaranteed Annuities (MYGAs)

MYGAs lock in an interest rate for the entire term of the contract, which might last three, five or even 10 years. The rate cannot change during this period, making it easier to plan around than a traditional fixed annuity, where rates can reset.

MYGAs often appeal to people looking for an alternative to certificates of deposit that offers tax-deferred growth.

Fixed Indexed Annuities

Fixed index annuities tie potential earnings to the performance of a market index, such as the S&P 500. While your money is not directly invested in the market, your credited interest depends partly on index performance, subject to caps or participation rates. Importantly, they include a guaranteed minimum interest rate, so your account will not lose value due to market downturns.

This blend of safety and potential growth can be attractive, although the crediting formulas can be complex.

Immediate Fixed Annuities

With an immediate annuity, payments begin shortly after purchase, often within a month. You exchange a lump sum for guaranteed income that lasts for a set period or for the rest of your life.

Retirees who want income stability right away often use immediate annuities to cover basic living expenses, such as housing and food.

Deferred Fixed Annuities

A deferred annuity allows your money to grow tax-deferred for several years before payments begin. This type suits individuals who are still working or have other income sources and want to lock in guaranteed income for later in retirement.

Insurance Companies Assume the Risk

The insurance company that sells you your fixed annuity assumes the lion’s share of the risk. When you purchase the contract, you’re essentially transferring your risk to the insurer. They promise to pay you a fixed, predetermined interest rate for the duration of the contract, regardless of economic conditions. This means that even if the stock market plummets or interest rates decrease, your income remains stable. This safety net makes fixed annuities an attractive option for risk-averse individuals.

Insurance companies select and manage investments that will yield a sufficient return to cover the promised interest rate and make periodic payments to you, the annuitant. They use reserves and actuarial calculations to predict and cover future liabilities.

If the investments underperform, the insurance company must make up the difference to ensure the agreed-upon payments are made to the annuitant. In essence, they bear the risk of the market’s unpredictability to deliver a steady income to the annuitant.

Pros and Cons of a Fixed Annuity

Fixed annuities offer several advantages. They provide the potential for a steady income, which can bring peace of mind to retirees. They also aim to safeguard the principal, shielding it from market volatility and trying to ensure that the annuitant’s nest egg remains intact.

Furthermore, fixed annuities offer tax deferral on investment income, allowing the annuitant to potentially grow their savings faster. They can also possibly leave a death benefit to heirs, making them a tool for estate planning.

However, it is important to understand the drawbacks of fixed annuities. They lack liquidity, as substantial surrender charges may apply for withdrawals made within the first few years. Additionally, fixed payments may not keep pace with inflation, potentially eroding purchasing power over time.

Be sure to seriously weigh these factors when evaluating whether a fixed annuity is the right retirement income strategy.

Potential Risks for the Annuity Holder

While the insurance company bears most of the risk, annuity holders or annuitants do face some limited risks.

For instance, if you decide to withdraw your money from the annuity before the contract’s maturity date, you may incur surrender charges or fees. Additionally, if the insurance company for your annuity were to face financial instability or bankruptcy, there could be a risk to your investment.

However, these scenarios are relatively rare, as insurance companies are heavily regulated to protect policyholders. Insurance companies must join nonprofit guaranty organizations in the states in which they operate. If a member company goes bankrupt, the other companies in the organization chip in to pay the remaining claims, up to $250,000.

Fixed annuities are also exposed to inflation risk because the purchasing power of their guaranteed payments can erode over time. For example, if an annuity holder receives $1,000 per month, that amount may not have the same buying power in 20 years as it does today, given the rising cost of living.

To address this risk, some annuity holders may choose to include inflation protection riders in their annuity contracts. However, these options often come at an additional cost.

Despite these risks, fixed annuity holders still stand to benefit from the security offered by these insurance products.

Bottom Line

A man looks over the paperwork for a fixed annuity that he's considering.

In the realm of fixed annuities, the distribution of risk is clear. The insurance company assumes the lion’s share of investment risk by guaranteeing fixed payments, regardless of market performance. On the other hand, annuity holders do face some risks, including the potential erosion of their purchasing power over time and the possibility that the insurance company goes under.

Retirement Planning Tips

Delaying Social Security beyond your full retirement age will boost your eventual benefit by as much as 8% per year until age 70. If you have enough money saved or other sources of income, you may consider the Social Security bridge strategy, whereby you defer your benefits and rely on your other income in the meantime. This allows your eventual benefit to increase and reach its maximum value.
A financial advisor can help you plan and save for retirement. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.