A fixed annuity is a retirement savings vehicle from an insurance company with tax-deferred growth. The principal remains the same, and grows by adding interest. It works similarly to a CD you allow to roll over to a new interest rate, except it grows tax-deferred. Fixed annuities can be immediate, or deferred. Immediate annuities offer immediate payments for a specified period, in exchange for a larger cash amount. Deferred annuities grow like a tax-sheltered CD.
History
Annuities were the first form of a personal old age pension for many people. They paid an insurance company money for the annuity until they reached retirement, then made an agreement for monthly cash payments the rest of their life. The insurance company used a calculation to reflect future interest, the life expectancy of the person, and the principal divided by the life expectancy. If the person died before the life payments used up all the principal, the company kept the balance. If the person outlived all the principal and interest, the company continued to pay. In other words, when a person "annuitized" the contract, they bet they'd live longer than expected, and the insurance company bet that they wouldn't.
Inflation
You might get a comfortable interest rate on your fixed annuity, and never see it drop in value. But what about the buying power of the money? You're saving so you can buy things later, but if your interest rate doesn't keep up with inflation -- the rising cost of goods and services -- you end up losing buying power. Fixed annuities often miss the mark, as do any fixed investments, over the long haul. If you're over ten years away from using the money, reconsider the purchase. If you annuitize the contract (take scheduled equal payments for a specified time, or payments for the rest of your life) the payments remain the same regardless of the cost of living. Some people do this so they'll never run out of money, but forget that inflation may still rob them of buying power.
Lost Opportunity
Lost opportunity isn't really a loss to you; it just means you missed ways to make more money. Fixed annuities lock up your money for awhile, because of early surrender fees imposed on contract holders of all ages, and federal penalties for those younger than 59 1/2. You can take the money or move it, but it costs you in penalties and fees, which might make it more costly than remaining in the contract.
Penalties
The insurance companies impose penalties for early removal from a fixed annuity, but the IRS does too. Since fixed annuities are retirement vehicles with a tax-deferred status, the IRS imposes a 10 percent penalty on the growth if you remove it before you're 591/2. Unlike Roth IRAs, where you can take out the principal first and avoid the penalty, annuities follow a LIFO rule (last in, first out.) Since interest is always the last in the contract, the IRS counts it as the first out, and you pay taxes and penalties.
Company Instability
While the state insurance guaranty fund protects your assets in insurance companies, similar to the way the FDIC does in bank products, there is a ceiling on the protection that varies from state to state. In addition, if the company is in a state of insolvency, there may also be a delay in receiving requested funds (See resources).