Is a Fixed-Index Annuity Right for Me?

Ah, annuities… some of the most complex investments out there. A dazzling variety of these in fact exist, but you’re likely interested in—and perhaps fixed on—a fixed-index annuity. In this article, we’ll discuss what exactly a fixed-index annuity is, its pros and cons, and how you can evaluate if a fixed-index annuity is right for your needs.

What is a fixed-index annuity?

We’re glad you asked—but to explain a fixed-index annuity, we first need to explain what an annuity even is.

An annuity is a type of insurance product that provides investors with a stream of income. You pay money up front (via a lump sum or series of payments during what’s known as the “accumulation” period), which is then invested and later paid out per an agreed-upon time, amount, and timeframe during the “payout” period.

All annuities have two components: the principal you pay into it and returns on the same. Depending on the type of annuity you set up, you can fund it with either pre-tax (qualified annuities) or post-tax (non-qualified annuities) dollars. Regardless of which option you choose, the earnings or interest on an annuity account can grow tax-free until the money is withdrawn.

Types of annuities

A fixed annuity is the simplest of the lot, with the lowest risk—and growth potential. With this option, the insurance company takes your money and lets it grow per the interest rate stated on the contract (akin to a CD). Your insurance company will typically offer an interest rate higher than the national interest rate—after all, if they didn’t, there’d be no benefit to putting your funds into an annuity instead of a bank. Provided you don’t withdraw your money during the surrender period (the timeframe in which you can’t withdraw funds without paying a fee), it’s impossible to lose money on this type of investment. While this might seem perfectly safe—you’re completely protected from the whims of the market—you do run the risk of having your returns gobbled up if the rate of inflation outpaces your guaranteed rate of return during your investment period.

In contrast, a variable annuity is the riskiest type of annuity to buy as your funds are tied to the performance of financial markets: with your insurance company investing your money into various stocks, bonds, and mutual funds (called “subaccounts”) directly for you. While you do enjoy the option of choosing the underlying investments, you could lose money (including your principal) if they ultimately perform poorly.

An index annuity, meanwhile, combines elements of both of these. Rather than going directly to the stock market, your money’s worth is tied to the stock index as a whole: meaning the better the Dow Jones or NASDAQ performs, the higher your returns. A large benefit of this approach is that you can only lose up to a specified amount of money, as these products come with a floor reflected in your contract (note this is sometimes a negative number). The downside of this type of annuity is that your returns will also likely have a maximum cap as well—but we’ll get to that in a minute.

So, just what is a fixed-index annuity, then? As its name suggests, this option combines elements of both fixed and index annuities: with some of your money placed in funds tied to one or more indexes while the rest is put into a fixed-rate fund. You’ll typically enjoy the opportunity to choose the proportion of your money that’s split between the two, and these money-earning approaches are referred to as “crediting strategies.”

Are annuities a good investment?

As with most investments, the answer here is “it depends”—as annuities aren’t for everyone.

The goal of an annuity is to provide you with a steady stream of income (typically during retirement), meaning these are often appropriate investments if you’re:

·      A conservative investor who wants to create a guaranteed source of income for the rest of your life

·      Worried about running out of money during retirement

·      Looking to protect your legacy (if you include a death rider, you can pass your annuity to one or more named beneficiaries, and inherited annuities won’t need to go through probate)

·      Already maxed out on all other retirement vehicles but want to continue funding your retirement

If you meet any of the above criteria, read on to better evaluate if a fixed-index annuity is right for you.

The positives of fixed-index annuities

• You won’t lose money. For the “fixed” portion of the annuity, the insurance company will offer you a fixed rate of interest for a specified number of years that typically resets annually but won’t fall below the company’s guaranteed rate. The index part of the annuity, meanwhile, offers more upside as it’s tied to index performance; but insurance companies will usually offer a 0% floor, meaning your money will only grow or go sideways rather than lose value.

• The initial premium is relatively affordable. As with all investments, annuities come with an initial premium that is sometimes quite steep. However, in many cases, fixed-index annuities offer less expensive premiums than variable annuities.

• You won’t outlive your income stream. Assuming you choose the lifetime payout option, you’ll have peace of mind knowing that you’ll always have a stream of income for the rest of your life.

• You can choose your level of risk. Fixed-index annuities will always remain a fairly low-risk, low-reward investment type, but you can personally select just how low you’d like to go risk-wise. After all, the premise of a fixed-index annuity is that a portion of your money will go into a fixed-rate account while the remainder is fed into an index fund. The proportion of money split between those two is up to you, meaning your fixed-index annuity can be as risky—or as safe—as you’d like (within some limits.)

The downsides of fixed-index annuities

• Your earnings will likely have a cap. This goes for fixed-index and index annuities alike. Remember how an index annuity caps your bottom interest rate at 0%? There’s in fact a dark side to that, as your maximum interest rate will be capped as well (e.g., if the index you’ve tied your index annuity to makes 10% but you have a 7% rate cap, you’ll only see a 7% interest rate).

• You’re sometimes only entitled to a percentage point of market returns. This is what’s known as a “participation rate.” Let’s say Sarah has a participation rate of 50% and the index she’s tied her funds to (again, this goes for both index and fixed-index annuities) has a growth rate of 8%. Because Sarah’s participation cap is 50%, she will only make a 4% return.

• Risk of losing buying power. During years in which the index portion of your annuity experiences zero (or very little) growth, you can lose buying power if the rate of inflation rises above your combined return.

• Delayed withdrawals. There are two other classifications of annuities: immediate and deferred. Fixed-index and fixed annuities are almost always deferred—meaning you can only withdraw after a specific period of time (typically six to 10 years). Any attempt to make an early withdrawal will likely result in steep surrender fees.

• Higher fees. While you won’t need to worry about any upfront fees, fixed-index annuities do charge and deduct fees from your account balance on an annual basis. These are generally higher than a fixed annuity or less complex investments such as an IRA.

Other considerations regarding fixed-index annuities

Unlike other tax-preferred retirement accounts such as 401(k)s and IRAs, annuities feature no contribution limits: meaning you can put in as much money as you want.

Perhaps you’re also wondering about the status of your fixed-index annuity after you pass away; the answer depends on your contract. Plans will generally provide a lump-sum death benefit to a designated beneficiary, but keep in mind you can also open the account as a joint contract: meaning you or your spouse can assume control and continue to receive payments should either of you pass away.

In sum: are fixed-rate annuities good investments?

Investing is always a balance between risk and reward, and fixed-index annuities are no different. However, as annuities are some of the most complex products available to investors, it’s important to speak with a financial advisor—ideally a CFP® professional who can objectively evaluate if an annuity is right for you.

———

Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and not intended to provide specific advice or recommendations for any individual. Fixed and variable annuities are suitable for long-term investing, such as retirement investing. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Withdrawals made prior to age 59½ are subject to a 10% IRS penalty tax, and surrender charges may apply. Variable annuities are subject to market risk and may lose value. Riders are additional guarantee options that are available to an annuity or life insurance contract holder. While some riders are part of an existing contract, many others may carry additional fees, charges, and restrictions, and the policyholder should review his or her contract carefully before purchasing. All guarantees are based on the claims-paying ability of the issuing insurance company.