Fixed annuities: Pros and cons

A fixed annuity may help you accumulate retirement savings without an annual tax bill cutting into your earnings. It also may provide guaranteed income backed by the strength of the insurance company that issues your annuity contract.

You might choose a fixed annuity to supplement other sources of guaranteed income, like Social Security or a pension. Fixed annuities can provide a stable income to cover your essential expenses in retirement no matter how the investments in your IRA are performing.

Fixed annuities have benefits and drawbacks. Understanding both can help you decide whether a fixed annuity is the right financial product for you.

A fixed annuity—also called a fixed-rate annuity or a traditional annuity—is a relatively simple and low-risk financial product. People choose fixed annuities for the lifetime income they can guarantee. It's important to understand that fixed annuities are neither a security nor an investment. They are long-term contracts between you and an insurance company.

There are two phases with a fixed annuity: an accumulation phase and a distribution phase. During the accumulation phase, you put money into your annuity by paying premiums. You might pay a single premium upfront or a series of premiums over time. Your premiums earn interest at a guaranteed rate that's backed by the financial strength of the insurance company that issues the contract. (Note that fixed annuities are not backed by the FDIC like bank-related accounts are or by the SIPC like brokerage accounts are.)

During the distribution phase, you can receive regular payments. These are usually monthly and can continue for a set period, such as a number of years, or for an indefinite period, such as the rest of your lifetime or your spouse's lifetime.

The typical fixed annuity buyer is at least 50 years old and focused on financial security for retirement. They also may have maxed out their retirement contributions and be seeking additional tax-deferred ways to save.

There are several benefits of fixed annuities that may fit with your overall financial strategy.

You won't lose money in a fixed annuity when the market declines. The insurance company takes on all the investment risk, and it invests its assets conservatively to protect its ability to pay contract holders. In addition, many contracts allow you to name a beneficiary to receive your annuity's full accumulated value when you die.

When you buy a fixed deferred annuity, you won't pay taxes on the growth in your annuity's value each year, which can help its value grow faster. You'll only pay taxes during the distribution phase. (When you buy a fixed immediate annuity, there's no accumulation phase since distributions start shortly after purchase.)

Not all annuities offer this promise, but fixed-rate annuities do. They have the least risk and the most predictability of the various types of annuities. You'll know at the time you buy your contract what interest rate it will pay; you may be able to earn a higher rate with a larger contract. The guarantee of a fixed annuity may help you feel comfortable taking on more risk with your investments or scaling back on work to volunteer more.

Fixed annuities have several income options: Fixed period, specified amount, single life and joint life. Choosing a lifetime income option can help protect against the risk of outliving your assets. Whichever option you choose, you'll know up front exactly what your monthly payout will be.

Some people have an unfavorable impression of annuities because some annuity contracts can be difficult to understand. Fixed annuities, however, are relatively simple. Reviewing them with a financial advisor can help you decide if fixed annuities are a good fit for you.

A fixed annuity is not the right choice for everyone. Here are the main drawbacks you should understand.

A fixed-rate annuity may not keep up with inflation. The inflation rate may be higher than the guaranteed rate your annuity contract pays.

A fixed annuity is a long-term contract where you trade liquidity for guaranteed income. Should you change your mind and wish to withdraw money from your annuity during the surrender period, which usually lasts several years, you typically will forfeit a percentage of your withdrawal—perhaps as high as 9%—to the insurer. This penalty may be waived under certain circumstances, but if you have to pay it, it may be higher than the returns you've earned, causing you to lose money. You also may pay a 10% tax penalty on withdrawals before age 59½.

The benefit of guaranteed returns comes with the drawback of limited upside. When the market performs well, your fixed annuity will not pay anything extra. Choosing a fixed annuity for its stability and security means forgoing the possibility of high returns on your premiums. To compensate, you might choose to take more risk in your investment portfolio to potentially generate more discretionary retirement income.

The earnings from your annuity have the benefit of being tax-deferred but also have the drawback of being taxed as ordinary income. By comparison, gains from the sale of investments held for one year or longer are taxed at long-term capital gains rates, which can be significantly lower than ordinary income rates depending on your tax bracket.

Depending on the contract you choose, fixed annuity payments can terminate when you die and leave nothing for your loved ones. And certain payout options—fixed period and specified amount—may end before you die.

If the cons of fixed annuities outweigh the pros for you, consider whether one of these other types of annuities could be a better fit for your preferences and risk tolerance.

If you'd like more opportunity for growth with safeguards to protect your premiums, a fixed indexed annuity could be right for you. It lets you benefit from a limited amount of the growth of a market index, such as the S&P 500 while protecting you against losses in years when the index doesn't perform well. Fixed indexed annuities also have a fixed account that returns a guaranteed interest rate. However, this annuity's lifetime income benefit has an additional charge that fixed-rate annuities do not.

Instead of low risk, you might prefer high growth. Variable annuities offer the potential for higher returns in exchange for the contract holder taking on more risk through investing in subaccounts. They also can be more expensive than other types of annuities, and your monthly payouts can fluctuate with changes in the market.

Thrivent's retirement income planning calculator can help you see where you stand and inform a conversation with a financial advisor about whether an annuity could help you meet your retirement income goals. An advisor can explain whether the benefits of a fixed-rate annuity would outweigh the drawbacks in your circumstances. They can help you create a comprehensive retirement strategy and evaluate whether annuities make sense as part of that plan.