Are you a retiree or pre-retiree looking for a retirement strategy with a guaranteed income stream? Fixed-indexed annuities may be the right choice for you. These annuities offer retirees and pre-retirees an opportunity to benefit from market gains, building upon the Index Investing Strategy. But they also include protections against principal loss, so you’ll never lose money!
Read on to learn more about how indexed annuities work, the benefits of purchasing them, and things to consider before buying a fixed-index annuity.
What Is an Indexed Annuity?
A fixed-indexed annuity is an agreement between you and an insurance company that can help protect your retirement savings from losses while still allowing you to enjoy growth based on the performance of market indices. It does so by linking your account’s performance to one or more external indices, such as the S&P 500 Stock Index. But unlike direct investment in the market, an indexed annuity provides a guaranteed minimum interest rate and protection against market losses.
Unlike fixed annuities, which pay set rates, indexed annuities offer their owners a way to increase the credited interest rate while providing some protection against downturns. In exchange for this protection, indexed annuities limit the upside growth. You’re essentially accepting less potential reward to minimize your risk.
How Indexed Annuities Work
An indexed annuity is like other types of deferred annuities in that you make a lump sum or series of premium payments to an insurance company. At a later date, your premium and any interest credited inside the annuity can be used to create a stream of income. The amount of the income streams depends on many factors, including your premium amount, the performance of the index, your age, and the payout option you selected.
While linked to one or more specific index(es), indexed annuities do not pass along the full value of any upticks in that index. The growth of your annuity’s account value will be influenced by one or more of the following limitations insurance companies place on the credited interest rate: participation rate, interest rate cap, or a spread/margin/asset fee.
A participation rate determines what percentage of the index’s gains will be credited to your account each contract year. Once credited, the value of the annuity fund is guaranteed. For example, if your participation rate is 40% and the linked index earns 10%, then 4% will be credited to your account.
A spread/margin/asset fee is a percentage fee that may be subtracted from the gain in the index linked to the annuity. For example, if your annuity has a 5% spread and the index gains 10%, your annuity will earn 5% for that period. If the index gains 25%, your annuity will earn 20% for the period. On the flip side, if the index only gained 5% or less in a crediting period, the annuity with a 5% spread would credit 0% for that period, though you may receive a contracted minimum rate in this scenario.
Lastly, the interest-rate cap sets the maximum amount that can be credited to your annuity during any crediting period. For example, if your annuity has a 7% cap, it can never earn more than 7% during a crediting period. If the corresponding index grew 20% in value, your annuity would still only earn 7% for that period.
Another aspect of indexed annuities that can make them difficult to understand is the various methods insurers use to calculate interest credits. Common crediting methods used on indexed annuities include annual reset, point-to-point, or high watermark.
- Annual reset involves taking note of where the indexed annuity closes at the end of the year. That number is then reset as your baseline for the following year’s gains, protecting you against losing previous years’ gains.
- A point-to-point strategy measures the performance of the index from one point in time to another. This can be monthly, annually, or even over a two-year period. The difference in the index values determines the interest credited for that period, subject to a participation rate, cap rate, and/or spread/margin.
- The high-watermark method calculates the return by taking several points during a 12-month period and then uses the highest mark to compare the previous year to the next.
Benefits of Fixed-Indexed Annuities
Fixed-index annuities are one of three major types of annuities. The other two types are fixed annuities (also called fixed-term annuities) and variable annuities. Fixed-term annuities offer guaranteed account values but do not include the potential for additional market earnings. Variable annuities offer higher potential for account growth but do not typically protect against principal loss.
While caps and participation rates can impact your growth during a market upswing, a fixed-indexed annuity still offers protection during downturns by crediting your account with a minimum rate that is usually between 0.1%-2%. The issuing company will, at specified intervals, adjust the value of your annuity to include gains that happened during that time frame. After each adjustment, previous gains become part of your protected principal, and cannot be lost.
Other benefits of indexed annuities include:
- Tax deferral: Your annuity’s account value grows tax-deferred, meaning you will not owe taxes on that growth until you begin making withdrawals.
- Inflation protection: Many indexed annuities offer a rider at an extra cost that provides income streams that increase annually based on the rate of inflation, which helps protect you against inflation erosion.
- Minimum guaranteed interest rates: Some fixed-index annuity contracts will set a minimum interest rate that credits some interest to your account even if the market doesn’t see any gains.
- Lifetime income: Many indexed annuities offer lifetime income riders at an extra cost that guarantee continued payouts until the end of your life, even if your annuity’s principal runs out.
Surrender Fees for Indexed Annuities
Most indexed annuities are subject to a surrender period. This is a period starting from the first day of your contract in which you cannot make withdrawals without paying a penalty to the insurance company. The penalty will be a percentage of the annuity’s account value at the time of withdrawal, with some being as high as 10%. Most contracts allow for a penalty-free withdrawal annually; your contract should outline this provision specifically.
Additionally, when attempting to withdraw funds prior to age 59 ½, you may incur tax penalties that could further reduce potential growth. Therefore it’s important to understand what fees or penalties may apply and plan out when withdrawals should occur to minimize their impact.
Purchasing an Indexed Annuity
If you are already retired or plan to retire within 5-7 years, a fixed-index annuity may be able to help you achieve your financial goals in retirement. Having a secure income source that you can’t outlive is a great reason to consider fixed index annuities. But, you must do your research and due diligence before purchasing.
Before you sign any contract, you must understand what money issues you want to solve, or what goals you want to reach. If you are looking for dependable, tax-deferred growth, need guaranteed lifetime income and principal protection, or want to leave a legacy for your loved ones, fixed index annuities might be the right option.
You will also want to find a trusted annuity expert in your area who can explain the moving parts of a fixed index annuity to you and your spouse. We recommend you consult a CPA or tax expert on all tax-related questions.
To speak to one of our certified annuity experts, fill out a quote form today.
NOTE: All guarantees are subject to the claims-paying ability of the insurer.
