Fixed Annuities: An Introduction

A Fixed Annuity is an investment where an Insurer guarantees an investor a fixed interest rate per year for a set period of time. The payments are Tax Deferred until the investor takes money out of the Annuity. Most of the time, Fixed Annuities offer a guaranteed interest rate for an introductory period (let’s say a year) then a subsequent (often lower) rate for the remainder of the Annuity term. Some have “surrender periods” much like other Annuities or a Certificate of Deposit (CD).

In fact, if this is starting to sound like a CD, that’s because they have a host of similarities. With that said, they aren’t that similar. CD’s are FDIC insured in the same amount as a bank account. 1. As a result, CD returns are very low relative to Fixed Annuities or any other investment, yielding negative Real Return after inflation adjustment and even more negative once adjusted for taxes on CD income. CD’s typically only have one interest rate for their lifetime, they are taxed every year (Fixed Annuities are not taxed every year and grow Tax Deferred), and surrender charges on taking money out of CD can actually eat in to principle whereas very few classic Fixed Annuities have the ability to do that.

All Annuities (Variable, Fixed, Immediate, etc.) have a few things in common: they can be Annuitized (i.e. turned into an automatic income stream for a set period or for life); they are offered by Insurance companies; and they enjoy Tax Deferred growth on returns in the Annuity contract until money is withdrawn.

Variable Annuities’ returns are varied based on investment performance within the contract, which means the investor is taking all of the market risk. Fixed Annuities are very different: they guarantee a set amount of return and the Premium (the amount the investor invests in the Annuity contract) is invested by the Insurance company in their General Account. In other words, all of the money coming in from investors creating new Fixed Annuity contracts is pooled together in the Insurer’s General Account and invested as a pool. This may sound technical or irrelevant, but it explains how with Fixed Annuities, the Insurer- not the investor- is taking the investment rate risk.

Fixed Annuity Investors are then paid their guaranteed amounts from money generated by this General Account. The insurer risks paying more than they earn. The investor is guaranteed a return whether or not the Insurer’s investments in the General Account are profitable.

With that said, investors take on a couple of other important risks that need to be considered.

Fixed Annuities are guaranteed by their issuers. Since these are not FDIC guaranteed, an investor should pay attention to the credit worthiness of the Annuity issuer, as that is what is backing the guarantee. This is similar to buying Corporate bonds versus U.S. Treasury bonds- one has the creditability of the Federal Government and its implicit ability to tax and print money, the other is backed by the continued profitability of a given company.

For example, New York Life issues Fixed Annuities and has a Credit Rating of AA+ from Standard & Poor’s, with Moody’s and Fitch rating them the same quality. This is considered a relatively low risk investment compared to similar investments by Credit Rating agencies, with AA+ being one step away from the highest possible rating.

By contrast, Phoenix (Nassau RE) also issues Fixed Annuities but received a BB rating from Standard & Poor’s. 2 This is a relatively low rating, with BB being below the cut off for Investment Grade bonds and falling into the “Junk” rating. Investors in their Fixed Annuities need to be aware of the elevated Credit Risk backing these Annuities.

The first thing you’ll read about a Fixed Annuity is its guaranteed rate. That’s put front and center when they’re being offered or advertised. This rate applies for a set term (often a year, but sometimes the entire lifetime of the Annuity). After that, you get a new rate. This new rate is often, but not always,  a lower rate than your initial guarantee.

There are many different styles (technically 9 at the moment) of Fixed Annuity, with a couple of them representing the majority of Annuities (Traditional and Indexed). I will introduce the most common of these styles as briefly as possible so that you know what to look for when these are being advertised to you. There are a couple that are rarely seen and very difficult to recommend- we won’t waste your time introducing them so as to keep this guide the most useful we can make it.

Be aware that most of the time, you’re going to be looking at Traditional Fixed Annuities (it’s not a coincidence that these are the simplest and most widespread) or some flavor of Indexed Interest rate. The style of Annuity determines what your subsequent, outside of guaranteed interest rate will be going forward.

This is the original Fixed Annuity. Originally, you had a very straightforward structure: 1 year guaranteed rate, a subsequent rate offered in the second year that applied for the rest of the term, and a surrender schedule that applied to the whole term. If an investor was offered a new rate in the second year (e.g. a drop from a guaranteed 7% to a 3.5%), the investor had to either surrender the policy or deal with it.

Today, these remain the most popular Fixed Annuities. One major difference today is that the surrender and guarantee periods match each other. If the guarantee period is 3 years, the surrender is 3 years. Longer surrender schedules are becoming the territory of the other styles of Fixed Annuities.

These Annuities offer a guaranteed rate for an introductory period- usually a year, much like Traditional Fixed Rate Annuities. After the guarantee period, the interest rate of the Annuity is tied to a bond index. As an example, An interest rate indexed annuity might guarantee 3% for the first year and base future returns on a 5 Year Treasury Bond.

These are some of the most complicated Fixed Annuities available. Unlike the above Interest Indexed Annuities, which reference the interest rate of another index, Equity Indexed Annuities (EIA’s) are based on the returns of a stock index, such as the S & P 500.

What makes them so complex is that investors do not receive a match of the Total Return of, say, the S & P 500. There’s a calculation called the “participation rate.” This tells investors what percentage of the return they get to “participate” in, with some of the return being excluded.

As a real world example, an EIA may have a “participation rate” of 100% up to a 7% cap. Everything after that cap will not be earned by the investor. One reason this can be a serious drawback for investors is that the calculation we use to say the average return of the market is around 10% a year acknowledges that we almost never have a 10% year for the S & P 500; we have years with 15% losses and 25% gains. The long term average is actually largely made up by a few years per market cycle of over 15%. Missing out on that excess return above 10% leads to a very large gap between regular Equity investors and EIA investors.

These annuities need the most research and caution from investors.

Bailout annuities are somewhat complex because they have 4 different interest rates:

1. The initial guaranteed rate (as with almost all Fixed Annuities)
2. The renewal rate (a market-based rate dictated by the insurer)
3. A long term guaranteed minimum rate that exists for the life of the policy
4. A Bail Out Rate which is the rate that lets investors “bail out” of the contract if the insurer offers a lower rate than this.

As an example, if the Bail Out Rate is 2.5% and the insurer offers a renewal rate of 2%, investors can take their principal and interest out of the contract without surrender fees. After the surrender period ends, the Bail Out Rate is redundant. With very long surrender periods (say a surrender that phases out over 10 years), this might be useful. These are more appropriate for older investors (over the age of 60), as there is a more limited concern about tax implications of taking the Bail Out Rate.

Certificate Annuities are essentially annuities with a Fixed Rate for a period that has a surrender period in force that entire time. If the Fixed Rate is 3 years, the surrender is 3 years.

We’ve seen many of these annuities come to market recently, and their process of renewal is familiar to investors as it is similar to a CD: the insurer tells investors the renewal rate of the Annuity at the end of the contract and if nothing is done within 30 days, it renews itself at that rate and a new surrender period begins as well.

The problem with calling these “CD Annuities,” as we have seen done occasionally over the years, is that these are just Annuities. They are not guaranteed by the FDIC and do not have the same insurance of principal. The guarantee is backed by the creditability of the insurer, just like all Fixed Annuities.

Interest crediting of Market Value Adjusted (MVA) annuities varies with the interest rates that insurers are earning. The problem with these as a Fixed Annuity is that the insurer is sharing more of the risk with the investor. Some MVA’s are even considered Variable Annuities by the SEC if they share too much risk with investors.

Our problem with these annuities is that they both take on market risks of a Fixed Income investment without giving investors to the same Total Return potential of a Bond or Bond Fund/ETF. With regular bond investments, investors are benefitted (or harmed) by market fluctuations not just in the interest rates themselves, but also the Capital Markets value of the bond. If rates fall, bond investors at least benefit by the value on the market of their bond going up. Insurers simply cannot make these Total Return potentials liquid enough to compare to bond investments for those investors willing to take on interest rate risk.

Bonus Rate Annuities are what they sound like: investors are offered a guaranteed interest rate for the first year that is not only higher than the subsequent rate after the first year, but high above market rates for similar annuities. That might sound great on first blush, but doesn’t amount to a real higher rate of Total Return over the life of the Annuity.

The problem is that the higher the first rate above the market interest rates, the lower subsequent years will pay. In the end, investors are paid similar rates to Traditional Fixed Annuities. The extra interest at the beginning has to come from somewhere.

These have never felt quite right to us. It’s kind of like a sing-up bonus that you end up paying for later, except that Bonus Rate annuities also typically have aggressive, high surrender fees. Getting out after the bonus period ends up costing investors that are better off finding the most reasonable average trade off over the whole annuity’s lifetime. What is disconcerting about these annuities is that they make it look like they have the ability to pay far above the rest of the market, and investors may not understand that they ultimately pay for that appearance.

The ideal use of a Fixed Annuity is to slowly build up contract face value through the interest rate crediting and eventually annuitize the contract, creating a reliable income stream to the investor. This rarely actually happens. Most of the time, these contracts go un-annuitized and are inherited by the beneficiaries of the owners, put in Trusts such as Charitable Remainder Trusts, or liquidated in lump sum.

So who fits the ideal description? In our opinion, Fixed Annuities need to be placed alongside other investments. This includes investments that will manage inflation risks, investments that have a high risk premium (certain stocks, Real Estate, and certain Fixed Income investments), and investments that have stable values backed by the Federal and Municipal governments.

A portrait of a family who could really use a Fixed Annuity might look like this (needless to say, this is not even close to the only investor who should own them): a married couple doesn’t have access to workplace retirement accounts through either spouse. They have only one child who is financially successful, making Legacy wealth a lesser concern. The couple has a diversified portfolio but sells a sub-par Real Estate investment, hoping to have more secure, passive income in retirement. The couple purchases a Fixed Annuity with a reasonable crediting rate and annuitizes it a couple of years into retiring. Alongside Social Security, the annuity income pays for much recurring expense for the family and the diversified portfolio is allowed to grow unencumbered by having to make regular payouts. This reduces longevity risk (the risk the couple will outlive their money) while hopefully providing an even larger nest egg for later retirement years, when cost of living becomes higher due to medical costs and eventual effects of long term inflation.

The above scenario is a pretty classic case study in Fixed Annuity integration into a plan. There are fascinating academic studies on planning with Variable and Fixed Annuities. We don’t tend to recommend such an insurance heavy strategy, but there are certainly cases where such uses make sense. The Fixed Annuity remains most relevant to Middle Class households that may have underperforming, higher risk assets that they wish to convert to much more conservative assets with some degree of tax savviness. You should also be getting the idea by now that Fixed Annuities are more appropriate for conservative investors with a lesser need for aggressive growth.