Fixed Where are premiums from fixed annuities invested vs Bonds A fixed annuity is a contract between an insurance company and one or more individuals, in which individuals make premium payments over the course of an accumulation period. The insurance company invests the premiums, then uses the investment proceeds to make distribution payments to the annuity holder.
These distribution payments typically span 10-20 years but may also last for the life of the holder. A bond is a debt security often purchased by older individuals seeking income from its interest payments and the security of principal associated with creditor status. Bonds carry maturities ranging from one year to 30 years. The effective yield of the bond depends on its price, which is free to fluctuate in accordance with market conditions.
Many characteristics of the fixed annuity are similar to those of a bond. This makes it useful to compare and contrast fixed annuities and bonds from the viewpoint of an investor. To get the best picture of which investment is best for your savings goals, compare rates on bonds and annuities through a licensed financial advisor. You can contact an advisor, free of charge, by requesting an annuity rates report below. Corporate bonds carry the risk of default, which can be minimized by choosing only from companies whose bonds are rated at least investment-grade by the bond rating agencies. Fixed-income investors with sufficient resources can also diversify their corporate bonds holdings to reduce the impact of default by a single company.
The default risk of municipal bonds is smaller, since city and state bankruptcies are much rarer than corporate ones. Default risk is smaller for insurance companies than for businesses generally, since their product is always in demand and the investments that backstop the company are professionally managed and diversified. Major ratings agencies rate the financial strength of insurance companies, which allows annuity buyers to avoid companies whose finances are shaky. Barring default, a bond investor can assure a specific return by holding the bond until maturity.
Thus, market risk becomes a problem only if the investor must sell prior to maturity. Market interest rates may rise, implying that the bond’s price must fall to preserve the interest yield of the fixed coupon amount. This fall in price will impose a capital loss on the seller. Fixed annuities preserve the investor’s principal by including minimum guarantees for interest and income credited to the accumulation account, thus insulating the investor against market risk. Don’t Just Shop, Implement a Solid Retirement Strategy Purchasing an annuity is a big decision.
Online research is a good start, but prudent investors should discuss all their options and risks with an independent financial advisor. Request a free, no-obligation consultation today, along with a report of current rates on brand-name annuities. Speak with an advisor over the phone about annuities for FREE. The penalty for bondholders is potentially larger in magnitude but lower in probability, which tends to balance out the comparative degree of risk. The purchasing power of fixed coupon payments and principal can be eroded by increases in the general level of prices over the term of the investment.
Recently, insurance companies have begun issuing fixed annuities whose investment accumulations are indexed against inflation. This may be a competitive reaction to the popularity of TIPS and I-bonds. Typically, indexation takes place once per year and is tied to a well-known index such as the CPI. Garden-variety fixed annuities may have an initial guaranteed rate that lasts only for a year or two, after which the insurance company is free to specify a lower rate. Ironically, CD annuities arose precisely because they lock in a guaranteed credited interest rate for the investment term of the annuity. Perhaps the surest way to deal with the problem of using annuities is to purchase an annuity whose investment returns are tied to a bond index rather than an equity index. Insurance companies invest in high-grade corporate bonds and blue-chip stocks in order to pay out interest to fixed-annuity accumulation accounts, so we would expect to find the latter yields to be somewhat lower than the former.
On the other hand, competition between insurance companies prevents this yield spread from becoming too wide. Consols are familiar to students of financial theory for their useful analytical properties, but unfamiliar to most people because they seldom exist in real life. As a practical matter, an annuity is the only way to assure a stream of income whose duration exactly matches the life span of the recipient. This is due primarily to the insurance-related, minimum-guarantee features that protect annuity-holder principal. In contrast, bond investments can usually be made inexpensively. Corporate bonds can be acquired with the help of a discount broker, as can municipal bonds.
Treasury securities can be purchased directly at little or no transaction cost. Annuity investment gains accumulate tax-deferred, which is another significant investment benefit. Municipal-bond interest is exempt from federal income taxes but taxable at the state and local level. Annuity gains are taxable as ordinary income when distributed or inherited.