How Safe Are Fixed Annuities?
Fixed annuities — including immediate, traditional fixed, and fixed indexed annuities — provide the owner of the contract with a guaranteed minimum interest rate and protection of his or her premium from market downturns. The guarantees of a fixed annuity are backed by the financial strength of the issuing insurance company. These guarantees are one of the differences between a fixed annuity, where the insurance company assumes the risk and a variable annuity, where the owner of the contract assumes the risk of the underlying investments. With a variable annuity, there is the greater potential for upside gains if the investments selected do well, but it is important to note that the principal is at risk and you can incur losses.
Risk and reward
Traditional fixed annuities are similar to bank CDs, in that they both credit interest to the account in a similar manner. The principal of a fixed annuity will never decrease, due to the ebbs and flows of financial markets. This guarantee is balanced with modest interest rates. However, rates are typically higher for fixed annuities than they are for CDs. The annuity accumulates interest on a tax-deferred basis, so the taxes on the interest income remain in the annuity, earning compound interest, until you begin taking it out. An annuity should be used for long-term retirement planning, not as a short-term savings account, as withdrawals before the age of 59.5 are subject to a 10 percent early withdrawal penalty by the IRS.
The type of annuity, surrender fees, and interest rates aren’t the only factors you should consider when evaluating the protection provided by an annuity. The financial strength of the issuing insurance company will also play a role. Life insurance companies are assigned a rating for financial strength by top rating agencies like Moody's Investors Services, Standard & Poor's Insurance Rating Services, Fitch Ratings, or A.M. Best Company.
These rating agencies each have their own credit rating system, but ratings are usually based on a scale similar to academic grading systems. A is the highest quality and every following letter is below this standard. However, the top financial strength rating is not A, but AAA, followed by AA, A, and A-. Next comes BBB, and the pattern continues down to F. Safer companies will typically fall in the range of BB to AAA. Standard & Poor’s is a good example of an agency that adopts this system.
Alternatively, the rating agency A.M. Best has a top rating of A++, with the rest of the grading system following this pattern. Keep in mind that state laws require annuity carriers to reserve assets equal to the total outstanding annuity contract obligations.
One of the attractive features of an annuity is to minimize tax obligations through tax-deferral. In the case of fixed annuities, interest credited will not be taxed while in the annuity. When withdrawals begin on non-qualified annuities (which means the annuity was purchased with after-tax dollars), interest credited to the annuity will be taxed as ordinary income and any portion considered a return of the premium is not taxed. As mentioned above, keep in mind that there is a 10 percent penalty for any withdrawals before age 59.5.