As we move through 2022, and given the economic uncertainty they face, aging consumers are becoming more familiar with the great intrinsic value of fixed annuity products (e.g., tax deferral, principal protection, guaranteed income options, unlimited purchase ability, and probate avoidance among others). Consumers are asking more questions about fixed annuities in order to improve their knowledge of the product.
In opening the door to interested consumers, financial professionals should fully comprehend the positives and negatives of fixed annuities and work to educate clients on all key product aspects.
Here are some major positives and negatives of fixed annuity products that can be helpful to discuss as part of the sales process.
Fixed annuities produce higher returns than do many other available fixed-income options. Fixed annuities usually offer rates of return higher than those of comparable duration-fixed income products such as certificates of deposit and money market accounts.
The insurance company manages the investments supporting the annuity. When a fixed annuity is purchased, the consumer is buying the money management capabilities of the life insurer issuing the contract. Life insurers have significant capabilities, as they manage large portfolios of assets using professional money managers.
Fixed annuities have options for guaranteed lifetime income. They possess the contractual option for the purchaser to receive guaranteed income they can’t outlive if a lifetime payout option is chosen.
A variety of payout options are offered. These options include receiving payments for a preselected number of years.
Fixed annuities offer tax-deferred income accumulation. No current income taxes are due on interest earned by the contract until funds are withdrawn from the contract. The contract owner gains the advantage of earning additional interest on the amount of taxes not currently paid.
For clients who want to avoid probate, fixed annuities are one way to accomplish that aim. Assets with a named beneficiary, such as annuities and life insurance policies, typically bypass probate.
Fixed annuities offer guaranteed rates of interest that are declared at least one year in advance by the life insurance company and come with life-of-contract minimum guaranteed interest rates.
The buyer knows the rate of interest they will receive and for what time period. These products appeal to individuals looking for a predictable return.
If your client is looking for principal protection and no risk of principal to market volatility, fixed annuities are not at risk for market changes due to fluctuations in interest rates or stock market volatility. They protect principal and are not subject to market-related losses.
The full amount deposited into a fixed annuity contract begins to earn interest immediately. Most fixed annuity products have no front-end loads or deductions from the premium deposited.
Newer fixed annuity products offer contractual riders that can provide optional income or offer benefits that can be used to pay long-term care and nursing home costs.
One negative is restricted access to cash. Fixed annuity products are not checking accounts.
They do not have complete, cost-free liquidity during the product’s surrender charge period. Most fixed annuities allow money to be withdrawn from the contract but with restrictions.
The three major ways to obtain access to cash from fixed annuity products are 1) by a partial withdrawal from the contract, 2) a full surrender of the contract and 3) by taking payments based on one of the contract’s options or optional riders. If the client takes more than a certain percentage of the contract’s value (usually 10%), they will be subject to a surrender charge.
Most annuities come with a surrender charge schedule that requires the buyer to pay a fee if they surrender the annuity contract in a certain number of years (i.e., typically 5 to 7 years). These fees can be significant. So it’s difficult to back out of a contract once purchased. Overall, only money that is being invested or saved for the medium-to-long term should be put into an annuity contract.
Income earned on fixed annuity contracts is taxed as ordinary income and not as capital gain for income tax purposes. For example, suppose a fixed annuity contract is purchased for $25,000, and the contract is surrendered 10 years later when its value has grown to $50,000. The gain in the contract of $25,000 will be treated as ordinary income and taxed at ordinary income rates in effect at the time of withdrawal.
Contractual bonuses come with strings attached. Many annuity contracts are sold with what is advertised as first-year bonus interest of 3% to 5%. The buyer should know that to fully earn these bonuses, they will need to hold the contract for a number of years, or, in some cases, they will only get the bonus if they take an income stream from the contract.
If the consumer takes withdrawals from a fixed annuity contract prior to age 59½, in most cases, they will need to pay an additional 10% tax penalty for taking the money out prior to that time in addition to income taxes owed on the withdrawn amount. Remember, annuities are intended to create supplemental retirement income, and withdrawals prior to that age trigger this penalty. There are some exceptions to this rule, and it is best to consult a tax professional to get the specifics.
If a fixed annuity is funded with pretax or qualified funds, the purchaser will not receive any additional tax-deferral benefit. Qualified funds are already tax-deferred by law and thus get no additional income tax benefit by being placed into a fixed annuity.
Another negative about fixed annuities is complexity. One of the cardinal rules of saving and investing is not to buy a product you don’t understand. Annuities are no exception. Consumers need to understand the contract they are purchasing as well as its key features, benefits, costs and restrictions.
Consumers are awakening to the value of fixed annuity products. As increasing numbers of consumers look to purchase these products, they need to fully understand that fixed annuity contracts provide guaranteed fixed rates of return, protection of principal and guaranteed lifetime income in exchange for certain restrictions. Fixed annuities are a financial tool that can be used to create tax-advantaged returns and guaranteed supplemental income in the later years of a client’s life.