Fixed Index Annuities. What Are They, And How Do They Work?
Annuities are financial products that some financial advisers strongly oppose while others strongly encourage. But the big question is, are they right for you?
Annuities may appear confusing owing to the numerous product types and possibilities available. On one end of the scale are high-fee, high-risk, high-potential-gain variable annuities, where your returns increase and fall with the stock market. On the other end of the spectrum are steady, CD-like fixed annuities with a fixed rate of return. However, one type of annuity can provide you with the best of both: the fixed index annuity.
What Are Fixed Index Annuities?
An FIA is a contract between you and an insurance company in which you give the company a set amount of money for a set length of time, and your return is based on the performance of a specific stock market index or indices. Your principal is guaranteed with FIAs, which means you will not lose money if the chosen indexes fall at the end of the year.
Clients frequently inquire, "What's the catch?" How can you not lose money with an FIA when the market is down? One possible explanation is that the insurance firm holds your money for a lengthier period of time and can reinvest it. Another possibility is that some FIAs can limit your total returns by using caps and participation rates.
A cap is just a ceiling or the maximum proportion of interest you can earn regardless of how the index performs. In other words, any gains that exceed the cap are forfeited. The interest you get with participation rates is a percentage of the overall gains of the chosen index, as decided by the insurance company.
Assume the insurance company establishes a 50% participation rate for a stock market index such as the S&P 500. If the S&P 500 increases by 10% that year, you will earn half of that increase or a 5% return on your investment.
Your FIA's index rates are fixed for the selected index's term, usually one or two years. However, those rates may rise or fall at the company's discretion during the contract term, often reflecting the current interest rate environment. This is known as the FIA's "renewal rate."
Benefits Of Fixed Index Annuities
The real benefit of fixed index annuities is that they safeguard against downside risk. Because many of our clients are approaching retirement and no longer accumulating assets, they do not want to lose 100% of their portfolio if the market has a bad year.
Another significant benefit is the yearly lock or reset option, which allows you to lock in your earnings when the annuity's index has performed well. The growth is then locked in and reset to become the initial balance for the following year.
Assume you have $100,000 in your FIA and a 5% return. You would start with $105,000 in your bank account the following year. Your FIA's value can only go up or sideways – never backward. So even if the index's value eventually falls or flatlines, your annuity will not lose money, and you will never fall below your new $105,000 floor.
FIAs can also be used to produce a retirement income stream. After the first year, almost all FIAs allow you to withdraw 10% of your account value without penalty. Furthermore, some FIA products with an income rider can generate a lifetime income stream, which we refer to as a private pension.
If you have an "income gap" in retirement, meaning your fixed income from Social Security and/or pensions is insufficient to fulfill your monthly budget, using FIAs for income can be appealing. In addition, using an FIA can shield your stock market investments from having to be liquidated in a weak market to create a monthly cash flow.
Another advantage is that many fixed index annuities do not charge any fees to the owner.
To Summarize
At the end of the day, there is no such thing as a perfect investment vehicle. If there were, there wouldn't be any financial advisors. FIAs, on the other hand, may be the right financial solution for some portion of your portfolio if you want a consistent source of safe income in retirement.
To have a better understanding of this financial tool, let's schedule a quick call so we can talk about your plans, future, and goals. This conundrum can be easily solved with a clearer perspective of what you want to achieve.
This material has been prepared solely for informational purposes and is not intended to provide, nor should it be relied on for, tax, legal, or accounting advice. Accordingly, before entering any transaction, you should consult with your tax, legal, and accounting advisors.
