Back to Basics: Fixed Annuities

WHAT IS A FIXED ANNUITY?

The best answer comes from Investopedia, a product of the respected Forbes Media Company:

A fixed annuity is “an insurance contract in which the insurance company makes fixed dollar payments to the annuitant for the term of the contract, usually until the annuitant dies. The insurance company guarantees both earnings and principal.

Investopedia rates Fixed Annuities as “fairly good financial instrument for those looking to receive a fixed investment income.”


WHY ARE THERE SO MANY KINDS OF FIXED ANNUITIES?
Fixed Annuities are among the most customizable investment vehicles available, and can be tailored to meet very specific situations. The cost of providing various special features is calculated into the overall charge for the annuity. Insurance components can be added to Fixed Annuities at a premium, and adjustments are made according to the length of the contract, whether it contains a survivor’s benefit, if it is for a “term certain,” or for “life.” These components vary considerably according to the age and health of the annuitant.


WHY A SINGLE PREMIUM?
A single premium is usually charged when one signs a contract that guarantees an immediate, regular stream of income for the annuitant. Generally speaking, people who want the security of a guaranteed income are the retired, the elderly, and those who are unable to work, usually because of health issues.
Often, these people are simplifying their asset mix – that very important balance of investment products that is most likely to guarantee against wild shifts of fortune. Many seniors who have selected annuities did so because they feared they might not outlive a stock market downturn. They had their ride on that roller coaster, and often enjoyed years of superior performance on their market investments.
But they chose to “cash in” by locking in the value of their investment successes.

Consider this: $1,000,000 invested in the Dow Jones Industrial Average Index Funds in September, 2007 would be worth only about $825,000 in march, 2008. That’s a loss of $175,000 in six months.
However, a 75-year old who would have invested just the $175,000 in a Fixed Annuity back in September, 2007, would already be collecting about $1,600 per month guaranteed for life with the most basic of Fixed Annuities. For a slightly smaller return, the annuitant could guarantee that sum for his heirs for 5, 10 or 20 years.
The important point: the older you are, the less likely you are to survive a bear market. Annuities can be an important part of the investment mix.

Myth #1
FIXED ANNUITIES ARE TIED TO THE STOCK MARKET
False! Fixed annuities guarantee fixed minimum interest rates throughout the life of the annuity contract. Your income and principal are preserved. The issuer of the annuities invests in long term instruments to guarantee a steady stream of income (usually monthly) throughout the life of the contract.

Myth #2
INFLATION WILL EAT UP MY INCOME
A law of economics tells us that money buys less with time. It is the principal of inflation, and one reason why stock investments are usually recommended as a large part of the investment mix for people during their working careers. The downside, as we have seen, is that stock investments have the potential to lose some or all of their value. Their dividends, if any, are never guaranteed, and may be raised or diminished by the vote of the board of directors. The stock market has a potential to “eat up income” (and assets) much more rapidly and unexpectedly than does inflation.
Some people simply can’t afford to lose a penny of their principal, and must receive a guaranteed income, regardless of inflation. Some are in a position to also maintain a stock portfolio. For them, Fixed Annuities provide a bedrock to stabilize their investments from wild swings up and down depending on outside market forces.

Myth #3
WHAT ABOUT THOSE SURRENDER CHARGES?
In order to maintain their guaranteed income, Fixed Annuities are invested in conservative, long-term investments. As is the case with many financial products, a penalty – called a surrender charge – is customarily imposed for early withdrawals of principal. This is to discourage annuitants from tapping into their funds prematurely, and to limit annuity purchases to those who plan to keep their money intact. The surrender charge, which itself may vary, reimburses the issuer for the considerable front-end costs of creating a Fixed Annuity for a client.