Using a Fixed Annuity for Fixed Income

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Last year was a tough year for fixed income investors. Most major bond indexes finished lower. Going forward, finding opportunities for value in today’s bond market isn’t easy. Valuations are soaring and persistently low bond yields can drive investors to chase yield – looking for income in risky places. That may not end well.

So, what should you do with your bond portfolio? Dump bonds altogether and go to cash? Cash is low yielding, and the interest is taxable. CDs? Not a fan. Interest on CDs is taxable, plus you lock into a low interest rate today, just when yields may be rising this year. There are other solutions, like building a diversified actively managed bond position, buying bonds at different maturities to capture more yield, or building a CD ladder by buying different maturities. But one solution that has a few interesting advantages is a fixed annuity. Here’s what I mean:

What is a fixed annuity?

A fixed annuity is a contract issued by an insurance company that guarantees* a fixed interest rate on your savings for a specified period of time. There are deferred and immediate fixed annuities. A deferred annuity focuses on accumulating savings, less so on income. An immediate annuity is for immediate income. I will focus on deferred fixed annuities.

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Who Should Consider an Annuity (and Who Shouldn’t)

When you purchase a deferred fixed annuity, the insurance company pays a rate of interest on the premiums invested in the contract, less any applicable charges. The interest rate is determined by the insurance company and is spelled out in the annuity contract. While the insurance company guarantees* that it will pay a minimum interest rate for the life of the annuity contract, a company may also pay an "excess" or bonus interest rate, which is guaranteed for a shorter period, such as one year. Below are the current rates, net of expenses, for a 5-year fixed annuity from a major insurance company:

Table shows the base rate for annuities of over $100,000 (2.30%) versus those under $100,000 (2.15%). Along with bonuses and escalating rates up to Year 5, the rates top out at 2.70% for annuities of $100,000 or more, and 2.55% for those under that amount

Disclaimer

Figure 1: Rates are for illustrative purposes only; actual experience may differ.

The year 1 rate includes the initial or “base rate” plus a bonus. In years 2-5, the insurance carrier guarantees the base rate will increase 0.10% annually. The rates can reset annually after year 5. The interest rates are higher for contributions over $100K. This is common.

Fixed annuity pros

Principal protection

The insurance company guarantees your principal from loss. Contrast that to a traditional bond, where prices can go down if interest rates rise. Keep in mind, the guarantee is only as good as the company offering it, so you want to pick a highly rated carrier.

Tax-deferral

Interest accrues tax-free each year that you wait to withdraw. Taxes are delayed until you take money out, then the earnings are taxed as ordinary income (assuming you purchased in a regular non-retirement account; qualified Roth IRA distributions are tax-free).

The 4 Phases of Retirement

In this low-interest rate environment, tax-deferral is a key advantage to using fixed annuities. The interest earned on Treasury bonds and CDs is taxable at ordinary income rates. The interest on municipal bonds is federally tax-exempt, but there may be state taxes and the interest could trigger an AMT preference item. Ideally you want to wait to withdraw from a fixed annuity till you are in a lower tax bracket, as in retirement, or at least until age 59½.

Higher interest rates

Fixed annuities typically pay a higher interest rate than CDs. Though this may not be a fair comparison, since CDs are guaranteed from loss up to $250K by the FDIC, a better guarantee than an insurance carrier (some readers may disagree). Either way, the interest on CDs is taxable each year, an important distinction.

Disadvantages or what to watch out for

No investment is perfect. Here are some things to keep in mind:

There is a penalty to withdraw all your money from a fixed annuity in the early years, usually years 1-5. However, most carriers allow you to withdraw 10% of the contract (interest and principal) annually without penalty.
Interest is taxable when withdrawn.
If you are younger than 59½ there is a 10% early withdrawal penalty.

For these reasons, you want to ensure you have other cash readily available for emergency purposes. For my clients in retirement, we usually have the interest paid out monthly from the fixed annuity – assuming it falls under the 10% free withdraw – to provide income.

You also want to choose a highly rated insurance company. Some fixed annuities pay high rates, but they are from a lower-quality company. High ratings are important, since the principal guarantee is backed by the claims-paying ability of the company. Check the insurer's ratings from agencies such as A.M. Best, Standard & Poor's and Moody's.

Final thoughts

If you want principal protection, tax-deferral and a competitive interest rate, a fixed annuity is worth considering for a portion of your fixed income. I say a “portion” because I do believe in creating a diversified fixed income portfolio – a mix of taxable and non-taxable bonds, Treasury inflation protected bonds, active and passive styles of management.

There is no one size fits all, only different strokes for different folks.

For more information on how a fixed annuity works, please email me at maloi@sfr1.com.

* All guarantees are based on the claims-paying ability of the issuing insurance company.

Disclaimer

Investment advisory and financial planning services are offered through Summit Financial LLC, an SEC Registered Investment Adviser, 4 Campus Drive, Parsippany, NJ 07054. Tel. 973-285-3600 Fax. 973-285-3666. This material is for your information and guidance and is not intended as legal or tax advice. Clients should make all decisions regarding the tax and legal implications of their investments and plans after consulting with their independent tax or legal advisers. Individual investor portfolios must be constructed based on the individual’s financial resources, investment goals, risk tolerance, investment time horizon, tax situation and other relevant factors. Past performance is not a guarantee of future results. The views and opinions expressed in this article are solely those of the author and should not be attributed to Summit Financial LLC. Links to third-party websites are provided for your convenience and informational purposes only. Summit is not responsible for the information contained on third-party websites. The Summit financial planning design team admitted attorneys and/or CPAs, who act exclusively in a non-representative capacity with respect to Summit’s clients. Neither they nor Summit provide tax or legal advice to clients. Any tax statements contained herein were not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state or local taxes.

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Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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Michael Aloi is a CERTIFIED FINANCIAL PLANNER™ Practitioner and Accredited Wealth Management Advisor℠ with Summit Financial, LLC. With 21 years of experience, Michael specializes in working with executives, professionals and retirees. Since he joined Summit Financial, LLC, Michael has built a process that emphasizes the integration of various facets of financial planning. Supported by a team of in-house estate and income tax specialists, Michael offers his clients coordinated solutions to scattered problems.