Fixed-income investors had a challenging time last year. The majority of major bond indexes ended the day down. Finding value in today’s bond market will be difficult in the future. With valuations rising and bond yields remaining low, investors may be tempted to chase yields and look for income in high-risk areas, which might not turn out nicely. So, how should you handle your bond holdings? Is it time to abandon bonds in favor of cash? Cash is a low-yielding asset with taxed interest. CDs? I’m not particularly fond of it. CD interest is taxable, and you lock in a low-interest rate now, just as yields are expected to rise this year. Other options include diversifying an actively managed bond portfolio, purchasing bonds with varying maturities to collect additional yield, or constructing a CD ladder by purchasing different maturities. Only one option, “a fixed annuity,” has several appealing features. Here’s what I’m talking about: What is a fixed annuity? A fixed annuity is an insurance policy that guarantees a fixed interest on the investment for a set length of time. Fixed annuities are of two types: deferred and immediate. The goal of a deferred annuity is to build up savings rather than to provide income. An immediate annuity, on the other hand, provides immediate income. This article will focus more on deferred fixed annuities. When you buy a deferred fixed annuity, the issuer pays interest on every premium you invest in the contract, minus any charges. The issuer determines the rate of interest for each contract and is specified in the annuity contract. Also, although the insurance company guarantees it’ll pay a minimum interest all through the life of the contract, they can pay an “extra” or bonus interest rate for a shorter period, like a year. The following are the current rates for a 5-year fixed annuity from a major insurance provider, net of expenses: 
In the annuity above, the first-year rate consists of the original, or “base rate,” and a bonus. The insurance company guarantees a 0.10% annual rise in the base rate in the 2nd year through the 5th year. After the 5th year, the rates can be reset annually. The rate is higher for contributions of more than $100,000, which are common. The Benefits of a Fixed Annuity Principal protection With a deferred fixed annuity, the insurance company protects your principal. In comparison, the price of a typical bond can fall as interest rates rise. Please remember that the warranty is only as good as the insurance company providing it, so choose a reputable carrier. Tax-deferral Each year you wait to withdraw, interest accumulates tax-free. You don’t pay the taxes until you get the money out, at which point they’re taxed as normal income (if you bought the annuity in a non-retirement account; the qualified Roth IRA distributions aren’t taxed). Tax deferral is a fundamental benefit of fixed annuities in this low-interest rate era. Ordinary income tax rates apply to interest paid on CDs and Treasury bonds, while municipal bond interest is tax-free in the United States. Moreover, state taxes, with interest, could activate an AMT preference item. Wait until you are in a low tax bracket, like in retirement or when you are at least age 59 and a half, to withdraw from a fixed annuity. Higher interest rates Fixed annuities pay a higher rate of interest than CDs. Although it may not be the best comparison, The Federal Deposit Insurance Corporation (FDIC) insures the CDs for up to $250,000, which is a better guarantee than offered by an insurance company (some people may disagree). CD interest is taxable each year in either case, which is an essential distinction. The cons of a fixed annuity investment No investment is without flaws. Here are a few things to remember when investing in fixed annuities. Withdrawing money from a fixed annuity early (usually years 1-5) carries a penalty. A lot of insurance companies, on the other hand, let people take 10% of the contract amount (interest and principal) out of it each year without having to pay. There is a 10% withdrawal penalty if you are under the age of 59½. The interest is also taxed when withdrawn. As a result, you’ll want to make sure you have extra cash on hand in case of an emergency. Most insurance providers typically have the interest sent out every month from the fixed annuity for their clients in retirement — if it comes under the 10% free withdrawal — to give income. It would help if you also went with an insurance company with a good reputation. Some fixed annuities provide high-interest rates, but they’re from low-quality organizations. High ratings are vital because the primary guarantee is based on the company’s ability to pay claims. Examine the insurer’s ratings from Moody’s, Standard & Poor’s, A.M. Best, and others. Conclusion As part of your fixed-income strategy, a fixed annuity is worth having if you desire principal protection, tax deferral, and a competitive interest rate. I say “part” because I believe in building a well-diversified fixed-income portfolio that includes a blend of Treasury inflation-protected bonds, non-taxable and taxable bonds, and active and passive management approaches.
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