An annuity is a contract between the customer and the insurance company for a savings plan with fixed principal and guaranteed minimum rates. The customer has the ability to let the annuity grow on a tax-deferred basis to be withdrawn later in a lump sum or the customer has the option to receive an interest income as frequently as monthly, the customer can also elect to receive the entire principal and interest in a series payments for a guaranteed period, or payments for life.
Christopher M Parr is the President of a major insurance brokerage firm in Overland Park, Kansas. His main focus is to benefit his clients and help them achieve their insurance and retirement income goals. “Before the client commits to a specific annuity contract,” he says, “I always advise them to consider the pros and cons of each type. They need to ask themselves how are they going to fund the annuity, when do they want to start receiving income from the annuity and finally, do they need or want a plan that the income is payable individually or jointly to a spouse as well.”
What is a Fixed Annuity?
The fixed annuity is the most popular and straightforward of all annuity types. As the economy goes through its usual cycles of ups and downs, interest rates tend to fluctuate which can impact premiums as well. However, a fixed annuity is immune to the turbulent markets as it provides a low risk and tax-deferred system where people get to grow their money safely.
According to Christopher M Parr, the reason for the fixed annuity’s popularity among customers is that these plans provide for interest rates guarantees therefore, both the interest and principal are guaranteed from the get-go. “A fixed annuity is safe, simple and predictable” he says. “It’s more like a what-you-see-is-what-you-get type of financial agreement.” The customer can elect to annuity grow on a tax-deferred basis and withdraw funds in a lumpsum at the end of the surrender charge period, without a fee or cost, or they can elect to receive a systematic payment of up to 5 to 10% of the contract value as frequently as monthly, it is a payment they can change or turn off and on as needed. Another option is to annuitize the contract, this is an option to receive a principal and interest payment over a specific duration, such as 5 or 10 years in equal payments, they can also annuitize the contract to guarantee a fixed payment for the rest of their life. It is important to remember that a fixed annuity always has the option to be paid in a lump sum, unless the customer to requests annuitize the contract in order to receive payments of the entire contract value over a specified period.
Benefits of Fixed Multi-year Interest Rate Guaranteed Annuity
Christopher states that Multi-Year Interest Rate Guaranteed Annuity plans are commonly referred to as MYGA’s, these are a single pay annuity issued with a guaranteed interest rate period which is equal to the length of time of the surrender charges, similar to a certificate of deposit. The interest rate guarantee period is usually between 2 and 10 years. Contract owners have the confidence of knowing the exact amount of interest their savings is earning each contract year. These annuities offer safe, simple and predictable retirement savings with tax-deferred interest accumulations that will grow faster than a comparable CD that is taxed annually or the contract owner can elect to receive their interest income each year, as frequently as monthly.
Benefits of Fixed Index Annuity Plans
Fixed Index Annuities are the most popular and widely used fixed annuity product. These plans earn interest based on positive increases in an equity index, normally the S&P 500. Participation rates, cap rates and spread rates may limit the interest credit and may not reflect all of the positive change in the index, but unlike a mutual fund, there is no downside market risk. Once interest is credited to the annuity for an index term, those earnings are locked in and any negative changes in the next index term will not impact the credited interest or the contract.
Fixed Index annuities offers the best of both worlds. It provides the low risk of traditional fixed annuities along with the interest credits based on an index, such as the S&P 500, without the downside market risk of being directly in the market, like a variable annuity or a mutual fund. According to Christopher M Parr, the low risk comes from fixed principal with no downside market risk to either the principal or credited interest. Fixed index annuities offer multiple index interest crediting strategies, each strategy calculates the index differently, this allows for a more diversified opportunity for index linked interest credits to maximize the growth and income potential
Disadvantages of Fixed Multi-year Interest Rate Guaranteed Annuity
One of the main disadvantages of the fixed interest rate annuity is right there in its name. The interest rate guaranteed in the annuity contract remains the same for the period of the annuity, even if other interest rates increase during that time. This is often referred to as inflation risk, in other words, as inflation rises, the cost of living goes up but your interest income will remain the same. Laddering maturities to take advantage of future interest rates in the hopes that interest rates will increase is a common hedge against inflation, but laddering maturities can also work against you in a declining interest rate environment, so according to Christopher M. Parr, working with a professional fixed income advisor can be extremely beneficial to maximize your retirement income.
“Another consideration regarding fixed annuities,” says Christopher, “is the surrender charges. Fixed annuity plans have early surrender charge periods that vary from plan to plan. Usually these plans will allow a penalty-free withdraw after the first year of interest or a fixed percentage, normally 5-10% of the contract value. A surrender charge may be deducted from your contract value if you withdraw more than the penalty-free amount during the surrender charge period. However, unlike a CD that penalizes the entire CD if you attempt to withdraw any principal, annuities have a better option, the surrender charge on an annuity is only on the amount over the penalty-free amount, with no penalty on the remaining contract value, this can result in a much lower charge if only a partial surrender in excess of the penalty-free amount is required. Tax consideration: withdrawals prior to age 59 ½ may be subject to an IRS penalty.
Other Annuity Types
- Variable Annuity: the variable annuity operates on the principle of high risk and high reward. The payouts are dependent on the performance of the stocks and other investments. If these do well, the client gets higher payments. But if the market goes badly, the contract value loses value and income payments suffer as well, in addition, these plans can have very high fees that are deducted from the contract year. Christopher M Parr states that while a variable annuity has more upside earning potential than a fixed or fixed index annuity, the direct downside market risk of a variable is not be suitable for most retirees. For those individuals wanting higher yield potential but do not want to subject their funds to the inherent risk of being directly in the market, Christopher recommends considering a fixed index annuity that offers some of the upside potential of a variable annuity but without the high fees and downside market risk that can result in a significant loss of value and income with a variable annuity or a mutual fund.
In terms of payout options, annuities can either give out immediate payments after the first year of the purchase or deferred payments starting at a later point in the future.
