The current interest rate environment has left those who rely on FDIC-insured savings vehicles for income in the cold.

The recent move by the FED to lower rates to zero has left little incentive for banks and credit unions to offer compelling rates to savers.

This has left savers searching for alternatives. If you find yourself doing the same, perhaps the idea of investing in annuities has popped up as a viable option. Read our guide below to help you in your decision making process.

What is an Annuity?

An annuity is an investment that will pay an income stream to an individual over time. The seller of the annuity invests the funds received, and distributes a stream of payments to the buyer over a period of years.

There are two important phases that impact the stream of payments. During the accumulation phase, dollars are invested into the annuity. To start payments, the investor must annuitize the annuity contract, which is called the annuitization phase.

Investor Choices

Annuities offer a number of options:

• Funding: The investor can accumulate funds in the annuity with a lump-sum payment, or using a series of periodic payments.
• Guaranteed income: An annuity can offer an income stream that is guaranteed for the annuitant’s life, or payments over a fixed period. Annuity payouts can also be based on a spouse’s life.
• Immediate payment annuity: You can invest a lump sum, and start receiving payments immediately.
• Investment options: Variable annuities give investors the option of using stocks, bonds, and other securities within the annuity contract.

An annuity can be compared to a defined benefit pension plan, or your Social Security payments. In both instances, the investor receives a stream of payments over the annuitant’s remaining life.

Factors That Impact Your Annuity

To understand what annuity is, think about a bucket. Dollars go into the bucket to fund the annuity during the accumulation period. When you annuitize the contract, image cutting a hole in the bottom of the bucket, and taking dollars out.

The payments include both your original investment, and possibly earnings generating by the annuity while your money was in the bucket. 

Annuities may be fixed or variable.

Fixed Annuities

As the name implies, this annuity is an insurance contract that guarantees a fixed rate of interest on the dollars you invest. In other words, the dollars in the bucket earn a fixed rate of interest.

Compounding Earnings and Tax Deferral

Your interest earnings are tax-deferred, meaning that you don’t pay taxes on the earnings until you annuitize and start withdrawing funds. By leaving dollars invested in the annuity, you compound your earnings on a tax-deferred basis.

Assume that you invest $10,000 in a fixed annuity that pays 3% interest a year. Your $300 in interest for year one is reinvested into the annuity. At the start of year two, you have $10,300 invested, and your earn 3% in year two. The total amount invested is larger, and you earn ($10,300 X 3%), or $309 in year two.

Compounding allows you to earn “interest on interest”, and you earnings increase at a higher rate. You earn $309 in year two, instead of $300. Earnings for two years total $609.

If you had to pay taxes each year, your total earnings would be much lower.

In this case, assume that you had to pay a 25% tax rate on your fixed annuity earnings in years one and two. Your after-tax earnings in year one total $225. If you started year two with $10,225, earned 3%, and paid a 25% tax on the earnings, your earnings in year two total $230. Earnings for two years total $455.

If you buy a fixed annuity while working, you may be in a lower tax bracket when you retire and take funds out at a future date. When you retire, your annual income may be lower, and so will your tax rate. If your tax bracket lowers from 25% to 20%, you’ll pay less in taxes when your start withdrawing funds in retirement.

Compounding earnings and tax deferral are huge benefits for an investor.

Managing Fixed Annuity Assets

Insurance companies invest fixed annuity funds into corporate bonds and government bonds. The money manager must consider the guaranteed rate of interest that the annuity must pay, and the earnings on the bond portfolio.

You may have the option of leaving your dollars invested in the annuity once the guaranteed period expires. The annuity seller may change the interest rate on the annuity, and offer you a guaranteed minimum interest rate.

Consider this scenario: The guarantee interest period on your fixed annuity is ending. Your fixed rate was 4%, but interest rates have fallen since you purchased the annuity contract. The annuity company offers a current rate of 3%, with a guaranteed minimum interest rate of 2%. The new terms may- or may not- be attractive to you.

Credit Rating For Insurance Companies

Your annuity payments depend on the credit rating of the insurance company that sells the annuity.

Insurance companies are rated by independent credit rating firms, which include Moody’s and Standard and Poor’s. These firms consider each insurance company’s asset, liabilities, and the investment performance of their portfolios.

Before you buy an annuity, ask your investment representative about the insurance company’s credit rating.

Other Fixed Annuity Considerations

Your checking account is a liquid investment, because you can withdraw funds at little or no cost to you. Annuities are defined as illiquid investments.

As explained above, a fixed annuity is an attractive investment for people who are willing to keep dollars invested for a specific period of time. If you have to withdraw funds due to a financial emergency, you may incur costs.

• Withdrawal limits: A fixed annuity limits the number of withdrawals you can make in a year, and the amount you take out. It’s typical for an annuity to allow only one withdrawal per year, and the amount must be 10% or less of the account value.
• Surrender period: Your annuity will have a surrender period. If you withdraw more than the annuity allows, you’ll pay a surrender charge on the excess withdrawal.
• Tax impact: Annuities are designed to fund retirement, which is why these products offer tax deferral on annuity earnings. If you make any withdrawal and your age is under 59 ½, you’ll pay a 10% tax penalty. The dollars you withdraw are taxed as ordinary income, at your current tax rate.

Annuities are expensive to create and manage. The insurance company must manage the insurance component of the product and the investment portfolio used to generate earnings. To cover these costs, annuity may charge higher fees than other forms of investing.

While a fixed annuity offers a number of benefits, you need to consider the costs. Also, if you need emergency access to the funds you plan to invest, a fixed annuity is not a suitable investment.

Indexed Annuities

An indexed annuity pays a rate of return based on an equity (stock) index. An index is a portfolio of stocks that is used to track market performance, or used as an investment vehicle. The Standard and Poor’s 500, for example, is an index of 500 well-known company stocks.

In some cases, the indexed annuity will pay a guaranteed minimum interest rate.

The best way to understand an indexed annuity is to review the features of a variable annuity.

Variable Annuities

A variable annuity’s value depends on the performance of the annuity’s portfolio of stocks and bond investments. Variable annuities do not offer a guaranteed rate of return. In some cases, you may earn a minimum rate of return, but the level of return will vary.

When you invest in a variable annuity, you choose from a variety of mutual funds investments. The mutual funds may invest in stocks, bonds, and other securities. If you own mutual funds in a retirement plan, you know that the risk and reward of funds can vary greatly.

Stock Mutual Funds

A stock fund investor can earn a return in several ways. A company may pay a cash dividend to shareholders, which is a share of the firm’s earnings. Stock investors also benefit if the stock price increases and the portfolio manager sells shares for a gain.

Stock funds are defined, based on the size of the companies in the fund. Company size is determined by capitalization, or the total market value of stock held by the public.

The Balance reports that US large capital, or “large cap” funds have an average 15-year return of 8.22%. Mid cap funds averaged an 8.09% return for the same period, and small cap fund earned 7.93%.

In addition to the rate of return, you need to consider the volatility of the stock mutual fund from year to year. A good tool to measure the volatility of the overall stock market is the Standard and Poor’s (S&P) 500 index. 

As this chart indicates, the performance of the index can vary greatly over time. During the last 20 years, you’ll note annual increases- and decreases- of over 20%. Investors should carefully consider the risks and potential returns of stock investing.

You may choose a variable annuity contract with a guaranteed death benefit amount. This option protects the value of your account, so that your heirs can receive a minimum amount when you pass away.

Bond Mutual Funds

Bond funds may invest in municipal bonds (issued by states and cities), government bonds (issued by the federal government), and corporate debt.

Bond funds are segregated, based on the average length of maturity of the bonds in the portfolio. Bonds may have maturity dates from a few years to as long as 30 years. A bond with a longer maturity date pays a higher amount of annual interest.

The average 15-year return on a long-term bond fund is 6.38%. An intermediate bond fund averaged 3.82%, and a short-term bond fund averaged 2.6%.

Bond funds, on average, have less volatility than stock funds. A bond fund invests in securities that pay a fixed interest rate, and mature on a specific date. If the portfolio manager buys a $30,000, 5% bond and holds it until maturity, the fund will earn 5% in interest per year, and receive the original $30,000 investment at maturity.

Bond investing offers the investor a more stable rate of return and less volatility. The bonds in the portfolio have a market value, but if the bond is held to maturity, the fund earns the interest and receives the return of principal.

Other Variable Annuity Considerations

You have more options when you invest in a variable annuity, rather than a fixed annuity.

• Funding: You can fund a variable annuity by investing a lump sum, or by making a series of payments over time.
• Accumulation period: Once you choose your mutual fund investments, your annuity dollars can stay invested indefinitely.
• Annuitization: If you choose to annuitize the contract, the annuity will start paying you, based on the value of your account and the type of payment plan you choose.

Variable annuities have restrictions that are similar to fixed annuities:

• Withdrawal limits: The annuity limits the number of withdrawals you can make in a year, and the amount you take out. 
• Surrender period: Your annuity will have a surrender period. If you withdraw more than the annuity allows, you’ll pay a surrender charge on the excess withdrawal.
• Tax impact: Annuities are designed to fund retirement, which is why these products offer tax deferral on annuity earnings. If you make any withdrawal and your age is under 59 ½, you’ll pay a 10% tax penalty. The dollars you withdraw are taxed as ordinary income, at your current tax rate.

Variable annuities are more expensive to manage, when compared with fixed annuities. A variable annuity is an insurance contract, and must be registered as a security with the Securities and Exchange Commission (SEC).

To cover the regulatory and management costs, variable annuity may charge a high level of fees.

What is a Bank CD?

Banks and credit unions issue certificates of deposit (CDs). CDs pay a higher rate of interest than savings and checking accounts, and the buyer is expected to leave the dollars invested for a specific period of time.

Bank deposits are insured by the Federal Deposit Insurance Corporation (FDIC), which means that dollars invested in CDs are federally insured against loss. Buyers will pay penalties for early withdrawal, however.

Before you purchase a CD, you should understand the current interest rate environment.

Current CD Rates and the Interest Rate Environment

Interest rates have steadily declined since 1981. The interest rate on a 30-year fixed mortgage has declined from over 18% in September of ’81 to under 3.5% today.

The Federal Reserve (Fed) recently announced an emergency interest rate cut to boost the economy, due to concerns regarding the coronavirus outbreak. Interest rates were already low before the emergency rate cut. Low rates of inflation allow the Fed to keep interest rates lower for a longer period of time.

Low interest rates also mean low rates of return on certificates of deposits (CDs) and savings account balances. A 5-year certificate of deposit pays less than 3% at most banks, and shorter-term CDs pay even lower rates. Savings accounts currently pay less than 2%.

Low rates of return may impact your monthly income, and your ability to grow your investment portfolio. If you’re interested in earning higher returns, consider annuity investments as an alternative to investing in bank CDs and savings accounts.

Major Differences Between CDs and Annuities

CDs are a low cost and highly secure investment for people who can commit funds for one to five years. Annuities offer higher rates of return, tax-deferral, and variable annuities can provide a diversified portfolio of stocks and bonds.

Annuities are more expensive than CDs, however, and the penalties for early withdrawal are greater in an annuity. Finally, variable annuities expose the investor to a potential loss of principal.

When Would a CD Be Right For You?

When you want to minimize investment risk, invest for five years of less, and keep your investment costs low, a CD may be right for you.

When Would An Annuity Be Right For You?

If you’re interested in taking a higher level of risk to earn more attractive returns, an annuity may be suitable for you. A fixed annuity offers a specific rate of return, and the opportunity to compound earnings on a tax deferred basis. 

Variable annuity earnings are also tax deferred, and you can invest in a diversified portfolio of stocks and bonds. Keep in mind, however, that variable annuities expose investors to more risk. 

Many investors use variable annuities to build a tax-deferred investment portfolio for retirement, or to pass assets on to heirs. A diversified investment portfolio and tax-deferred growth are attractive benefits to many investors who need to invest for the long term.

Both fixed and variable annuities are more expensive than CDs, and charge higher penalties of early withdrawal. If you need the invested funds to cover a potential emergency, put your dollars into a checking or savings account.

Final Thoughts

Talk with a financial advisor, and do your homework. Consider the potential risks and rewards for each investment alternative. 

Make sure that you understand the fees you must pay, the guaranteed rates of return you’ll earn (if any), and the penalties incurred for early withdrawal.

If you diversify your investments, you can earn a higher return than rates on bank CDs and savings accounts.