Fixed income annuities offer a low-risk opportunity to guarantee income payments. But there are some pitfalls to be aware of. Here’s a basic rundown of how they work and what to keep an eye out for.
A fixed annuity contract starts with a lump-sum payment (or several payments over a period of time) to an annuity provider. This is known as the “accumulation phase.” Once the accumulation phase is complete, the provider agrees to pay a fixed return over a set period of time. This is the distribution phase. And it can take place over a number of years or for the rest of the contract holder’s life.
One of the benefits of this type of investment is that it’s insulated from the markets. No matter which direction the Dow or S&P 500 heads, the return will remain steady. This is why they can be perfect for someone living on a fixed income.
Fixed income annuities operate in a similar way to a certificate of deposit (CD). This type of financial instrument offers a set rate of return. But with fixed income annuities, the return is typically higher than CDs offer.
The Good Side of Fixed Income Annuities
When setting up a fixed income annuity, the contract holder is essentially creating their own defined benefit plan or pension. Every month, like clockwork, the checks will arrive in the mail. And it’s worth noting that just like regular pay, fixed income annuities are taxed as income.
The certainty that comes with annuities can offer peace of mind and make planning for the future easier. Contract holders know exactly what kind of return they can expect.
Setting them up is a lot easier than many other forms of investing too. While the returns from investing in the stock market offer a greater return long-term, surefire stability goes a long way. And comparing fixed income annuities can be much easier than spending lots of time researching companies to find the ones that deserve your investment.
Banks, brokerages and insurance companies are among the most popular providers of fixed income annuities. And it’s relatively easy to compare the terms and rates to find the one that best suits you and offers the best return. But beyond comparing terms and rates, it’s vital to do your homework on the company issuing the fixed income annuity. Read on to see why…
The Bad
The money you have in your checking or savings account is insured by the Federal Deposit Insurance Corporation (FDIC). Same goes for money market deposit accounts and certificates of deposits. Fixed income annuities, however, are not insured by the FDIC.
While annuities are usually insured in other ways, it’s important to do your own research. Make sure to invest in fixed income annuities only through companies that are unlikely to go bankrupt.
Another – more legitimate – drawback to fixed income annuities is that they are relatively illiquid. Most place limits on your ability to withdraw money. And long guarantee terms mean it can take a long time to see a full return on your investment. So when exploring annuity choices, read the fine print. Make sure you know the withdrawal abilities and penalties upfront. You don’t want to find out about a 10% penalty when you need access to funds for an emergency.
And while a lack of access can be a real disadvantage compared with other investment vehicles, the simple truth is that fixed income annuities don’t offer a great return on investment. Sure, they’re competitive compared with CDs, but not compared with the Dow Jones Industrial Average.
A fixed income annuity might garner around a 3.5% annual return. The stock market, on the other hand, averages around 8% to 10% annually. This is why simply investing in a Dow-tracking ETF can be more lucrative. The SPDR Dow Jones industrial Average ETF (DIA) and iShares Dow Jones US ETF (IYY) both have an excellent history of successfully tracking the Dow’s return rate.
Nonetheless, the steadiness offered by fixed income securities can go a long way. But there are even more insidious issues to be mindful of…
The Ugly
If inflation starts to tick up, a fixed income annuity can’t always keep up. This can lead to a loss of value on the investment. There are ways around this, though. You can add a cost-of-living adjustment (COLA) rider to the contract. This can help fixed income annuity payments from losing value due to inflation. But this can lead to a decrease in the first round of payments due to fees associated with the rider.
And that’s not the only place fees pop up. In fact, the fees associated with fixed income annuities can be just as damaging as high inflation. Insurance charges and investment management fees can put a real damper on an annuity’s return. And those are on top of the aforementioned rider fees and possible withdrawal fees.
Fixed Income Annuities: The Bottom Line
There are scores of investment opportunities out there to help prepare and successfully navigate retirement. And for some, fixed income annuities are the perfect choice. They’re simple to set up, are low-risk and can be especially helpful for those who have trouble managing money… After all, you can’t spend what you don’t have access to.
But they come with their fair share of issues as well. Having your money locked up in an annuity can be problematic in the event of an emergency. Then there’s the simple truth that investing in the stock market offers the opportunity for a greater return. And on top of that, there are the fees – both hidden and in plain sight. So again, even a relatively straightforward investment in a fixed income annuity requires some homework.
This article originally appeared on Investment U.
