A fixed annuity is a tax-deferred investment vehicle with an insurance component. It generally guarantees you will earn a set rate of interest on your initial premium over a predefined period without paying taxes during that period. The interest rate that is offered is determined by market conditions and can change periodically. Once you purchase the annuity, you lock in a set rate of interest for the period of the annuity. What makes this look alluring is the fact that you know exactly how much money you will have earned by the end of the guaranteed period, and if you die within this period, your heirs will get the full amount of what you've been guaranteed -- that's the insurance angle.

However, most fixed annuities come with many strings attached that complicate matters quite a bit. There are tax issues to worry about, bonus interest rates that make the product look better than it is, surrender and withdrawal fees that cut away at your earnings, a multitude of payout options, a 10% federal penalty if you withdraw before the age of 59-1/2 and the low base interest rate that hides behind the guaranteed rate for the period of the annuity -- the list keeps getting longer.

After a good amount of debate on this subject, the consensus is largely against investing in fixed annuities (or any other annuity, for that matter) unless you fit into a very specific group. The conditions under which a fixed annuity would become a reasonable investment option are: if you've maxed out your 401(k) and IRA and still want a tax-deferred investment; you plan on keeping the annuity for at least 20 years; you won't need the savings until after age 59-1/2; you don't care that your heirs will be paying ordinary income tax on any appreciation; your tax bracket now is higher than the tax bracket you expect to be in when you begin getting payouts; and you want a guaranteed source of income during your retirement.

Compared with many of the other fixed annuities I looked at, Vanguard's Single 5 Fixed Annuity is relatively straightforward. You are required to invest a minimum of $10,000 and currently, you're guaranteed a 5.10% interest rate (as of 4/1/02 -- it can change at any time before you purchase it so check Vanguard's website for details by following a path from the "services" link) for the first five years of the annuity. After that, the interest rate will be reset annually, never lower than 3.25%, or you can use the funds to buy a new annuity and lock in a new interest rate for another five years without incurring surrender fees. By virtue of the relative simplicity of this product over others I've seen and the higher base rate they're guaranteeing (most others I saw were 3% or less), I think that Vanguard is making as solid an offering as one can find in the fixed-annuity market.

While Vanguard's annuities are better (and less expensive) than the majority of annuities offered in the marketplace, I still recommend that you buy them only if you've exhausted all other tax-deferred options. If you are considering investing in one in the future, be sure to shop around and really examine the product that your money will be locked into.

More of Dan Wiener's advice on Vanguard's annuity funds is available on the www.AdviserOnline.com members-only website. For subscription information, see Become A Member.

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