 Personal Finance Powerpoint Presentation. Fixed annuity. Prepare to get financially fit by practicing personal finance. Most of this information can be found at Investopedia Fixed Annuity which you can find online. Take a look at the references, resources, continue your research from there. This by Julia Kagan, updated April 25th, 2021. In prior presentations we've looked at insurance in general, going then to the life insurance. Now we're taking a look at what is a fixed annuity. A fixed annuity is a type of insurance contract that promises to pay the buyer a specific guaranteed interest rate on their contributions to the account. So when we're thinking about annuities in general, we're thinking about in essence a series of payments. When we're thinking about investing in an annuity, we're generally thinking we're going to give a lump sum upfront possibly to an insurance company to have some form of series of payments at some future point. Possibly part of our retirement plan strategy. The fixed annuity is the more kind of conservative type of annuity because you could basically map everything out upfront. You might not have as much exposure to basically the gains if you were to type to other things like variations in the market for example. But it gives you that kind of guarantee or more of a guarantee in terms of the dependability on how much return you're going to get and how much therefore you might be receiving when you start receiving the annuity payments in the future. So by contrast, a variable annuity pays interest that can fluctuate based on the performance of an investment portfolio chosen by the account's owner, by the account's owner. So a variable annuity then is going to be tied to some in some way shape form to the stock market, which is going to be fluctuating. That's the term variants. So I would always be thinking about an annuity first thinking about it with kind of like the standard annuity, a fixed annuity where everything's basically lined up and set up and straightforward for the most part upfront as much as it can be. And then take variants from that looking at different types of annuities such as indexed annuities and variable types of annuities, noting that oftentimes when you're thinking of annuities, you're trying to set up a dependable stream of payments into the future, possibly during retirement and you want to be measuring out the pros and cons of trying to get exposure to more gains versus the possibility that that could also expose towards less gains or like losses at the same time. And so the fixed annuities probably like the baseline one that you want to first be thinking about to get a grasp of annuities and then look at variants from there as necessary. So fixed annuities are often used in retirement planning how a fixed annuity works. Investors can buy a fixed annuity with either a lump sum of money or a series of payments over time. The insurance company in turn guarantees that the that the account will earn a certain rate of interest. So there's where it's fixed. You got a certain rate of interest, which is locked in, which if if it's not tied to any other investment so on, that makes everything a little bit more straightforward upfront. This period is known as the accumulation phase. When the annuity owner or annuitant elects to begin receiving regular income from the annuity, the insurance company calculates those payments based on the amount of money in the account, the owner's age and how long the payments are to continue and other factors. So in other words, you've got it growing when you're putting the money into the annuity and then at some future point you're going to be electing to take the money out. The money coming out will be coming out in like an annuity and a series of payments, which will be dependent on factors such as the age, how long the payments are to continue and other factors. This begins the payout phase. The payout phase, they continue for a specified number of years or for the rest of the owner's life. Now, if it was a specified set of years, you're going to say, well, you're going to be paying out the annuity up for so many years, like 20 years or something like that. Then it's a it's even more kind of straightforward to do the calculation because you know basically how long the payout is going to be. But oftentimes you're setting up the annuity so that it pays you for your lifetime in retirement, which means once you start having the annuity payments paid out, you don't know when the end date is going to be because you're going to die. You want it to get the payments until you die at some point. So you might think, well, how does the insurance company figure that? Obviously, they're going to have to be dependent on some annuity tables, for example, to try to figure life expectancy. And this is why the life insurance companies work well with the annuities are one reason because they often work with these actuarial type of tables and they can't determine when you specifically will die. But if there's a bunch of people that they have annuities with in the big pool, they can have a decent consideration in terms of who dies when, for example, on average, that means from a big numbers perspective, they can get an idea of how much would be paid out if the payments are going to go towards until death and then possibly using that pool method figure out then how much the payments would be. During the accumulation phase, the account grows tax deferred, then the account holder annuatizes the contract distributions are taxed based on an exclusion ratio. So in other words, if you think about how the annuity is put into place, when you put the lump sum into the new annuity, make payments into the annuity, that shouldn't be a taxable event because that's kind of like you putting principal into an investment. But then hopefully they're going to give you a rate of return, a fixed rate of return if it's a fixed annuity, which if it was outside of the annuity and like a bank account, and you were receiving a fixed rate of interest, for example, you would be getting yearly 1099s and having to report that and record income on it. You're not having to do that because it's deferred tax deferred when it's in the annuity. But then when you start taking the money out, you could have a tax consequence. Now the problem is that you've got some of the money in there that was your money that was principal and some of it as being interest. This is different a little bit than like a 401k plan oftentimes or an IRA, because when you put money into a 401k or an IRA, you usually get a tax benefit upfront. So if you put money into the IRA, you get a deduction or something like that. If it's in a 401k, it wasn't included in income. So it's not just the income that was not included or taxed. But it's also the original principal. So that's not the case here because you would the original income that you got was your money that you already pay taxed on it went into the account. So that principal wouldn't be taxable. When you take it out, you would think just the interest that you got when you when it grew. So and then that might be taxable when you pull it out. So this is the ratio of the account holder's premium payment to the accumulated in the account that is based on gains from the interest earned during the accumulation phase, the premiums paid are excluded and the portion attributable to gains is taxed. This is often expressed as a percentage. So this situation applies to non qualified annuities, which are those not held in an annuity retirement plan. In the case of a qualified annuity, the entire payment would be subject to taxes. And that might be because when you put the money in, if you got the tax benefit of putting the money in up front, then then that is another deferred tax in a similar way as if you got like a deduction when you put it into an IRA, I believe. So benefits of a fixed annuity. Owners of fixed annuities can benefit from these contracts in a variety of ways. Predictable investment returns. So this is kind of the point of the fixed item. You might say, well, that sounds kind of bland, kind of boring. But that's kind of the point it's fixed. And so that the so you don't have that variation in the income, it's not tied to the market. So that you're not going to get the highest return on it generally. But you want to be you're looking for something usually here that would be a dependable return. So the rates on fixed annuities are derived from the yield that the life insurance company generates from its investment portfolio, which is invested primarily in high quality corporate and government bonds. The insurance company is then responsible for paying whatever rate is has promised in the annuity contract. So in other words, you might say, Well, how is this kind of working? It's kind of like a bank, right? When they when you put money in the bank, you say, Well, how how can they possibly make money? They're charging me basically nothing. And I'm getting my checking account and all this kind of service. Well, that's because the money in the checking account, they're not holding on to all of it. They're investing it in some way, getting a return on it, keeping enough money to manage their accounts. If you tell, say the insurance company that here's my money, and I'm not going to take it out, I'm guaranteeing to you to some degree that I'm not going to take out the principal, then they have more leeway to basically do more investments on their side of things to try to get a return and then be paying you of course, whatever they promised you in the contract. So that's how they're going to make their money. So these contracts with variable annuity, this contrasts with variable annuities, where the annuity owner chooses to underline investment and therefore assumes much of the investment risk. So if you have a variable annuity, then you're choosing the things that are going to be invested in getting a piece of kind of the risk that's going on, as opposed to kind of getting that fixed return, guaranteeing minimum rates. Once the initial guaranteed period in the contract expires, the insurer can adjust the rate based on the stated formula or on the yield it is earning on its investment portfolio as a measure of protection against declining interest rates fixed annuity contracts typically include a minimum rate guarantee. So we still have this adjustment that takes place here, but we've got the rate kind of fixed for the time frame, which gives a little bit more assurance during that period. So once the initial guaranteed period in the contract expires, the insurer can adjust the rate based on a stated formula or on the yield it is earning on its investment portfolio as a measure of protection against declining interest rates fixed annuity contracts typically include a minimum rate guarantee tax for deferred growth because a fixed annuity is a tax deferred vehicle, its earnings grow and compound tax deferred. That's one of the benefits of the annuity that's similar to if you put it into an IRA or a 401k, for example, annuity owners are taxed only when they take money from the account that's similar to a standard kind of IRA or traditional IRA either through occasional withdrawals or as regular income. So these tax deferral can make a significant difference in how the account builds up over time, particularly for people in higher tax brackets. The same is true of qualified retirement accounts such as IRAs and 401k plans, which also grow tax deferred. So when you're doing tax planning for retirement, you would like to be able to kind of kind of put some of your money in the tax deferred stuff and possibly have some money that you can take out that wouldn't be subject to tax that you'll be living on, for example, to try to lower your taxes at the point in time that you're retiring and you're living off of this income because if you're living off the income of the tax deferred income, then you might be paying some taxes, of course, on the annuity, although possibly not the entire amount that's being paid is taxable because you had that premium portion that possibly was was not a taxable component. If you're taking money out of an IRA or a 401k, then that's all going to be subject to taxation at retirement as well. So you want to be able to kind of plan if you can lower the income or the income subject to taxes at that point, it would be good. So guaranteed income payments fixed annuities may be converted into an immediate annuity at any time the owner selects. The annuity will then generate a guaranteed income payment for a specified period of time or for the life of the annuitant. Relevant relative safety of principle, the life insurance company is responsible for the security of the money invested in the annuity and for fulfilling any promises made in the contract, unlike most bank accounts, annuities are not federally insured. So that's one of the downsides. The federal insurance on the banks is supposed to stop people from doing like a run on the bank. There's not that same kind of so that means that the bank went out of business, you should be able to get paid by the government, for example. But there's not that same kind of assurity with the insurance companies. You're not really going to think about having a run on the insurance companies generally, because they can't just pull the money out of the bank account like they can with the banks. So maybe it's thought that there wasn't as much of a need, but the insurance company is doing the same kind of things that banks are doing and that they're taking the money, which is kind of more guaranteed to the insurance company. So it's not like it's just in a checking account that you can go ask for it back at any time generally. But then they're taking that and investing it, obviously, and trying to figure out how much money they're going to have to return. If the stock market completely just crashed and the insurance company made poor investments and whatnot, could they go bankrupt or stuff like that? Possibly. It's like, you know, not likely, but possibly. And you wouldn't be have that same kind of insurance you do that you have to the bank account. So for that reason, buyers should only consider doing business with life insurance companies that earn high grades for financial strength and from major dependent rating agencies. Criticisms of fixed annuities. I don't like that shirt they wear. Any case, annuities, whether fixed or a variable are relatively illiquid. In other words, not liquid. In other words, if you put money into other kinds of investments, you can typically get to the principle a little bit more easily. For example, fixed annuities typically allow for one withdrawal per year up to 10% of the account value. This makes them inappropriate for money that an investor might need for a sudden financial emergency. So in other words, if you were to put your money into like the stock market, for example, just in like stocks and bonds, then you could pull the money out fairly quickly if you wanted to get access to the principle. The whole point of the annuity is that you're putting money into an annuity given a guarantee in essence to the insurance company, at least to some degree, that you're not going to be pulling the money out, which allows them to invest it and give you this kind of annuity payment. So it's not something that you can, if there's an emergency, just jump into and take your money back out. During the annuity surrender period, which can run for as long as 15 years from the start of the contract, withdrawals of more than 10% are subject to a surrender charge imposed by the insurer. Annuity owners who are under age 59 and a half may also have to pay a 10% tax penalty in addition to regular income taxes. So the fact that the annuities grow on a tax deferred basis means that there's a cost to that. You're putting them under the umbrella, and the IRS is saying, I'm giving you that because we don't want you to pull the money out until retirement. So if you pull the money out, then you get a tax penalty possibly. And mind that to pay taxes on it. Finally, annuities often carry high fees compared to other types of investments. So if you were to just put the money into just an index fund, you know, using E trade or something like that or Vanguard or something, then it's usually relatively low costs for the for that. Whereas the the annuities are higher. Anyone interested in annuity should make sure they understand all of the fees involved before they commit. It also pays to shop around because fees and other terms can vary widely from one insurer to the next.