An annuity is an insurance contract that guarantees regular income payments over an agreed upon time or lifetime, typically tax-deferred growth and protection against market losses. There are different kinds of annuities such as fixed annuities and indexed annuities regulated by state insurance commissioners; while indexed annuities fall under SEC oversight.
Rate of return
Fixed annuities are long-term investments that provide a guaranteed rate of return over an agreed time. Payment can either be immediate or deferred, with deferred annuities giving owners tax-deferred growth that helps build wealth while providing retirement income security.
Insurers’ fixed annuity portfolios consist of relatively safe investments such as bonds. When bond rates increase, insurers pass along those higher yields to consumers as more generous fixed annuity rates – an explanation why the annuity market has been so prosperous since 2023, with average fixed annuity rates tripling over 18 months.
Buying a fixed annuity requires careful consideration of its features and fees, as well as shopping around and comparing rates from several highly rated insurance companies. You should also verify whether or not the annuity is insured by state insurance guaranty associations.
As well as offering guaranteed rates of return, some annuities also provide the potential for higher returns by investing in indexes or ETFs. These annuities are known as indexed annuities and operate similarly to fixed annuities; with two important differences. These instruments credit interest based on growth while protecting principal against declines – this is accomplished using part of your annuity premium to purchase call options in a competitive bidding process from various investment banks.
Index annuities may provide the potential for higher returns than traditional fixed annuities; however, their net rate of return may not always match what has been advertised due to how they are structured and potential declines in investments underpinning them. Furthermore, insurers often charge fees and impose restrictions that reduce how much interest can be paid back into contract owners’ accounts.
Investors should keep in mind that fixed annuities don’t typically account for inflation and do not provide cost-of-living adjustments, so if considering one it is essential to discuss inflation protection with their financial advisor.
Crediting methods
Insurance companies make money from fixed annuities by investing premium payments in fixed-income portfolios that offer returns without market risk – giving an insurer the ability to offer guaranteed rates of return on annuity principal. Other forms of annuity (variable annuity in particular) invest contributions directly in the market and thus become more susceptible to market fluctuations and potential market losses.
Insurance companies utilize different crediting methods when crediting fixed annuities to generate profit, such as the “new money method” or a portfolio-based approach. Some use the “new money method”, with each new deposit of premium receiving its own interest rate; this strategy is particularly common with flexible premium fixed annuities which collect multiple premium payments over time.
Many insurers provide deferred fixed annuities with an initial, guaranteed rate of interest that lasts from several months to several years, after which time an insurer will apply a renewal rate that may either be lower or higher depending on economic conditions and an insurer’s business goals.
Insurance companies sometimes sell riders that allow the principal of an annuity to earn a higher renewal rate than its initial contract’s initial rate, known as a jump rate rider. This option is available to existing fixed annuity owners looking to boost their income payouts; some riders provide lifelong income while others can help provide payments after death to beneficiaries or spouses of annuitants.
Insurance sales professionals frequently make the false claim that fixed annuities do not expose owners to market risk; this is simply untrue. In reality, some fixed annuities include clauses in their contracts which allow an insurance company to reduce an annuity owner’s account value during severe market conditions and charge administrative fees that may substantially lower investment balances for some clients.
Inflation risk
Inflation risk can be a real concern for investors, but it can be lessened through diversifying investments and including realistic inflation estimates in your financial planning process. This approach is especially valuable when choosing long-term investments such as retirement savings plans. A Thrivent financial advisor can help clarify your retirement goals while outlining steps you can take to limit inflation risk exposure.
Fixed annuities may seem attractive to retirees looking to lock in a predictable rate of return over their lives, but it is essential that they read and comprehend all the fine print associated with this form of investment. Excess fees can eat into net rate of return while insurance companies often alter key factors that reduce returns – this change in contract.
An annuity investment typically poses lower levels of risk than variable annuities with greater volatility, but you should still exercise caution if seeking guaranteed rates; some agents and insurers advertise annuities by promising high interest rates or promising more benefits than they actually provide. Furthermore, many of these products charge surrender fees if money is withdrawn early.
Consumers often fail to realize that annuities are insurance contracts rather than investment products; therefore they are not covered by FDIC or SIPC guarantees.
When purchasing a fixed annuity, look for a company with an excellent track record in the industry and high marks from objective rating agencies. Also consider an annuity with shorter deferral periods if your expected lifespan is short; in recent years the Attorney General’s office has filed lawsuits against insurance companies who sold unsuitable deferred annuities with 15 year or longer deferral periods to people who weren’t expected to live that long.
Some fixed annuities do not include cost-of-living adjustments, which can cause your purchasing power to depreciate over time. To mitigate this risk, choose an annuity with this feature as an optional contract rider.
Fees
Insurance companies make their money off fixed annuities by charging fees and collecting premiums, investing them into investments with guaranteed rates of return, then crediting contract owners with their guaranteed rate of return as stipulated in their annuity contract. They may also charge fees for features or benefits they provide – such as annuity rider fees.
Insurance company profits depend on a balance between investment yield and interest credited to contract owners. Investment yield refers to what an insurance company generates from traditional investments such as corporate bonds and mortgage-backed securities; part of it goes toward crediting contract owners while another portion covers acquisition and maintenance expenses and provides profit for their insurer.
Insurance companies also generate profits by taking on longevity risk. Actuarial science and claims experience help insurers determine the average lifespan of annuity purchasers and factor that into their products – the longer their average lifespan, the lower will be their annuity payouts. Furthermore, insurance companies incur overhead expenses including administration, marketing, and advertising that must also be covered.
Insurance companies may impose surrender charges for early withdrawals of an annuity; these penalties are intended to discourage investors from withdrawing their money before its time has come. Financial professionals, however, caution that these fees should not act as an disincentive against investing in an annuity.
Annuities’ tax advantages make them attractive investments, particularly to investors seeking safe places to park their savings and secure retirement income streams. But it’s essential that investors understand all fees associated with annuity contracts before deciding if one is suitable. When purchasing one from a life insurer with high ratings from independent rating agencies – otherwise you risk losing a significant portion of savings! Additionally, consider opting for deferred annuity agreements instead of immediate ones as these may have greater long-term advantages than immediate ones.