For those investors near or in retirement, finding reliable and steady sources of return and income is a paramount issue. Bonds and other fixed income assets are often used by investors and advisors to meet this need. However, as last year’s bond rout showed us, bonds aren’t always a safe play for portfolios. To that end, new solutions may be needed to steady portfolios and provide ‘sleep at night’ protection.
Enter the humble fixed annuity.
With their steady and guaranteed rates of return as well as the ability to provide income, fixed annuities are getting a good look from many investors. If they are not, they should be.
Fixed Annuity Basics
Annuities have long been a ‘troubled’ investment product, riddled with fees, escape clauses, and swarmy salespeople. However, thanks to the low-fee revolution and more top-notch insurance companies now getting into the mix, annuities are finding their way as a real portfolio tool. Advisors—including RIAs—are now finding all types of uses for annuity contracts in portfolios. And that includes fixed annuities.
Fixed annuities offer opportunities for the accumulation and decumulation phases of retirement. Like all annuities, fixed annuities are a contract between an investor and an insurance company. Here, the insurance company is willing to pay the investor a guaranteed and fixed rate of return for a certain period of time, say 3% to 4% annually for five or ten years. At the end of the contract term, investors can either take the money, reinvest it in another fixed annuity or begin lifetime income payments.
Like all annuities, the fixed annuity and its crediting interest are tax-deferred and is only taxed when investors withdraw funds from the account, via occasional lump-sum withdrawals or as regular income payments.
Why Use a Fixed Annuity in a Portfolio?
Given their steadfastness, fixed annuities make for a bond sleeve complement or replacement. Often, investors look toward bonds for their stability and steady coupon payments. However, with the Bloomberg U.S. Aggregate Bond Index returning a negative 13% in 2022, this relationship has been turned on its head. Investors were reminded that bonds do not always go straight up. However, because of their guarantees, fixed income annuities do not lose value and will pay out what the contract says. This can provide the stability that investors crave from bonds and provide actual ballast.
Second, their tax deferral offers a better deal than bonds or even certificates of deposits (CDs) for investors looking at using after-tax money to fund their annuity purchase. Bond and CD interest is taxed as ordinary income rates, every year, if placed in a taxable account. However, investors purchasing a fixed annuity with after-tax money—also called a Non-Qualified Annuity—is able to defer the taxes on the investment. This adds to additional compounding and better after-tax returns.
Better still is that when investors start taking withdrawals or lifetime income from the fixed annuity, not all of the payment amounts are taxable at once. Annuity payouts are split into a principal component (what you invested/not taxable) and an earnings component (gains/taxable). This potentially can keep investors in a lower yearly tax bracket and help reduce ordinary income taxes.
And speaking of that lifetime income, annuities are the only way investors can get a guaranteed stream of income each and every year during retirement. By using a fixed annuity during acceleration phases to get a steady return of returns and then during accumulation using lifetime income options, investors have a powerful combination to meet income needs.
Advisors and investors agree. According to a survey by WealthManagement.com, the most important features of fixed income annuities are principal protection (87%), downside market protection (86%), and predictable income (57%).
Now Could Be a Great Time for Fixed Annuities
For investors looking at stability and safety, now could be a great time to take a serious look at fixed annuities as a bond complement or replacement. The Fed’s rate hikes were the main reason why bonds fell over the last year or so. However, the inverse has been true for fixed annuities. These days, fixed annuities are offering crediting rates in the 3.5% to 5.5% range, depending on time, length of contract, and issuer strength. That’s well above the 1% to 2% just a year ago.
For example, various fixed annuities issued by MassMutual, New York Life, and USAA are currently paying 3.5%, 3.8%, and 4.10%, respectively. Investors can score up to 5.06% from AIG on their American Pathway Fixed 7 Annuity depending on which version is purchased. Those are very attractive after-tax returns when compared to a CD or bond fund.
And investors don’t potentially have a ton of money either to start using a fixed annuity for their portfolios. Many do offer lower initial investments or the ability to make additional investments as investors see fit. A fixed annuity issued by A++ rated Guardian Life can be purchased with only $5,000.
Things to keep in mind include costs/fees, crediting terms, and lifetime income. All annuities have surrender charges for ending the contract early as well as annual fees. Keeping these as low as possible helps keep more of an investor’s money in their pockets. Second, the highest interest rate may not be the best deal for a portfolio depending on strength or issuer or potential lifetime income options. It pays to shop around and investigate before hitting the purchase button.
The Bottom Line
Bonds are typically used as ballast for a portfolio. However, last year’s rout underscores that they don’t always go up. This is where a fixed annuity could be great for portfolios. Offering guaranteed crediting rates and principal protection, these annuities offer a host of benefits for investors. Using them to replace or complement bond holdings could be a good idea.
