Think of a fixed annuity as a sort of "reverse" life insurance contract. A fixed annuity essentially turns an up-front, lump-sum investment (the premium) into a known amount of monthly income for the rest of your life. Fixed annuity rates will generally follow interest rates. With rates near record lows, fixed annuities offer low returns relative to recent history. But that doesn't mean you should ignore them; in fact, fixed annuities can provide dependable income in retirement.
How fixed annuity rates work
Your return will vary most directly with your life expectancy. A 75-year-old can expect to receive larger monthly payments from a fixed annuity than a 60-year-old, all else being equal. A recent quote, for example, showed that a $100,000 investment would provide a 75-year-old male with roughly $760 in monthly income, compared to $500 for a 60-year-old male.
Compare the monthly benefit to the expected interest from a bond fund to see why annuities are so popular. High-quality bond funds pay about 3%-4% in annual interest in the current low-rate environment, or about $250 to $333 per month in interest on a $100,000 investment. That's roughly one-third as much income as a 70-year-old could expect from a fixed annuity.
Why buy fixed annuities?
Fixed annuities are attractive because they are relatively simple by design. Where a typical life insurance contract protects you from the financial implications of an early death, an annuity protects you from outliving your savings.
Thus, the upside to a fixed annuity is that you know exactly how much you'll receive each and every month for the rest of your life. Unlike variable annuities, the return isn't influenced by changing interest rates or rising or falling stock prices. What you are quoted is what you will receive.
This provides valuable certainty in a world that is anything but certain. After all, you can't necessarily rely on receiving the same amount of dividends from a stock portfolio or the same amount of interest from a bond fund. You can, however, be confident that a fixed annuity will pay the same amount for as long as you are living.
Risks of a fixed annuity
As with any investment, fixed annuities come with some risks. The first risk, albeit small, is that the insurance company that wrote your policy goes bankrupt. This risk really depends on the state in which you reside, as insurance companies are regulated by states, and annuities are insured to varying degrees by state governments. Alabama provides up to $100,000 of guarantees, but New York will provide a guarantee of up to $500,000, for example. You can minimize your risk by buying an annuity from a top-rated firm. Credit agencies such as A.M. Best rate insurers by their financial stability. A rating of A+ or better is ideal.
The second risk is that of an early death. Most fixed annuities pay only until the buyer passes away. It's possible, though improbable, that you could buy an annuity and die before receiving a single monthly payment, resulting in the loss of your entire premium.
You can moderate this risk by selecting a policy with a "cash refund," which pays out any remaining premium to your heirs. A cash refund annuity will pay out less in monthly income, but can be useful as a tool to ensure that if you pass away early, you won't lose your investment. Your heirs will receive the unused premium.
Finally, because a fixed annuity pays out a fixed amount each month, you run the risk of inflation eating into your monthly income. From 2010 to 2015, inflation averaged 1.9% per year. Over longer periods, inflation has been higher, about 3.2%, on average.
If recent inflation rates hold constant, you can expect your spending power to fall by about 17% in 10 years. Thus, an annuity that pays $1,000 in monthly income today will equate to about $830 in spending power a decade from now. Naturally, diversification helps. A fixed annuity works best when paired with other, riskier assets such as stocks, which have generated inflation-beating returns over history.
As with any financial product, fixed annuities are commodities. Virtually any life insurance company in the annuity business can and will write a fixed annuity, so use competition to your advantage by shopping around for the best possible rate.