Fixed Indexed Annuities
Fixed indexed annuities are often touted as an investment strategy that can provide income during retirement. But the average investor can find them confusing and even intimidating. We’ll investigate what they are, how they work, and what their advantages are.
What Is a Fixed Index Annuity?
A fixed index annuity is an investment product designed for safe, steady long-term growth that’s issued by an insurance company. As the name indicates, it’s a fixed, not variable, annuity linked to the performance of a specific stock index, such as the S&P 500, without being directly invested in any market index. A fixed index annuity offers the potential of index accumulation and higher interest rates than a traditional fixed annuity. There’s a minimum guaranteed interest rate and no fees on the base product. Adding rider benefits is an option, but one that, in almost all cases, shouldn’t be used. Fixed indexed annuities may be subject to surrender charges and holding periods, and they vary by state and carrier, so due diligence is a must when you’re researching your options.
How Do Fixed Indexed Annuities Work?
Think of a fixed annuity as a chunk of your net worth earmarked for growth in the long term (five, seven, or ten years) with no downside risk and with partial annual access to that chunk of money. Just like when you’re comparison shopping for CD rates, normally the longer you lock in, the better the rate. Also consider that some insurance companies give different rates depending on the amount invested, so you could get a better rate by investing more. And the partial annual access means that a small amount, usually 10 percent, of the total investment isn’t subject to the contract term and is available to withdraw if needed. For example, of a $100,000 seven-year investment, you could access $10,000 each contract year.
The insurance carrier will offer a variety of investment buckets within the fixed annuity.
Every contract year, the carrier will offer renewal rates for each bucket. You can change allocations each year in most cases. Let’s examine the different buckets.
- Bucket 1: The Fixed Account – This bucket guarantees a return on your money by simply earning interest. The interest rate is declared annually, and even in negative markets, positive interest accumulates daily.
- Bucket 2: Annual Point to Point – The strategy of this bucket involves using a market index, such as the S&P 500, to earn interest on your investment up to a maximum cap. You can earn from 0 to 6 percent interest if 6 percent is the cap. If the S&P 500 goes up 10 percent, you earn your maximum rate of 6 percent. If the S&P 500 goes down 10 percent, you earn your minimum rate of 0 percent. If the S&P 500 goes up between 0 and 6 percent, you earn that interest rate.
- Bucket 3: Participation Rate – In this bucket, interest is calculated as a percentage of the index growth for the contract year and credited annually without a cap. So if the participation rate is, say, 50 percent of the S&P 500, you earn 50 percent of the return over the one-year term, but not less than 0 percent, even if the market return is negative. So if the S&P 500 has a 10 percent return, you earn 5 percent; if it has a 15 percent return, you earn 7.5 percent; if it has a 4 percent return, you earn 2 percent.
- Bucket 4: Monthly Average – In this bucket, annual credit is based on the average index value for the year relative to the starting value. It has unlimited potential to take advantage of bull markets, but a spread fee that reduces the value of the return usually applies.
Asset Allocation Strategy
Here’s a sample allocation for an entire portfolio that includes a fixed annuity, which is meant to provide a block of safety within the bigger-picture strategy for overall net worth.
Tax Benefits (Nonqualified Version)
Earnings on fixed indexed annuities are tax-deferred. You don’t have to pay federal income taxes on the gains of your annuity investment until you withdraw money from it – which is a significant benefit. Think of it this way: if you’re in the 32 percent tax bracket and your tax-deferred rate of return is, say, 5.1 percent, you’d have to earn a 7.5 percent return on a taxable investment to realize the same gain as on your tax-deferred investment. That’s extra bang for your buck thanks to tax payment savings!
Top Fixed Annuities and Fixed Indexed Annuities
Here I will frequently update the best rates I see in the marketplace for fixed annuities and fixed indexed annuities.
|Over 100K||Under 100K|
Fixed Index Annuity
|5-Year Term||Bucket 1: Fixed Rate||Bucket 2: Point to Point Cap||Bucket 3: Participation Rate||Bucket 4: Monthly Average Rate|
|7-Year Term||Bucket 1: Fixed Rate||Bucket 2: Point to Point Cap||Bucket 3: Participation Rate||Bucket 4: Monthly Average Rate|
|10-Year Term||Bucket 1: Fixed Rate||Bucket 2: Point to Point Cap||Bucket 3: Participation Rate||Bucket 4: Monthly Average Rate|