The Fixed Index Annuity is also referred to as an equity indexed annuity. It is an annuity that allows for the possibility for upside appreciation in the stock market, but protects against risk of loss to principal due to unexpected market changes.
Does this sound too good to be true? Gain without loss? Many people initially brush fixed index annuities aside as a gimmick or don’t take a minute to understand how they work. Don’t sell yourself short though- they are well worth investigating because if you like what you learn they might have a place in your portfolio.
First, lets do a little housekeeping though.
The Terms Fixed Index Annuity and Equity Indexed Annuity often refer to the same product.
It is confusing for advisors and clients alike, so don’t feel bad! The correct term, however, is Fixed Index Annuity as this is squarely an insurance product, and not a security. The term ‘Equity Index Annuity’ infers an equity component and thus more in the realm of a security offering. While there was a push to regulate these annuities as securities in the past, it was thankfully defeated.
These are squarely insurance products as they are primarily a fixed annuity, whose earnings are used to participate in market gains. More details in just a minute….
Is a Fixed Index Annuity Right For You?
Fixed index annuities are a good deal, but only for the right investor and the right reasons. We can’t say if that’s right for you till we get to know your situation.
But the typical buyer of a fixed index annuity seeks the potential for growth without risk of loss, values principal protection, and appreciates tax deferred compounding of their investment capital.
Fixed Index Annuities are great for a safe money strategy, and are often used to make sure principal is safe, and to preserve assets and options for later.
Often, fixed index annuities are used for simple safe growth without a need for income. It’s critical to select the right contract for this job, because contracts optimized for growth are different than those designed for income.
Compare the Fixed Index Annuity to the Hybrid Annuity
By contrast, the typical ‘hybrid annuity‘ buyer is attracted to the potential for growth, but is also seeking to secure lifetime income from their principal at the time of their purchase. Other benefits vary by contract and include certain death benefits, home health care riders, rollup rates and bonuses.
It’s crucial to know that the annuity contract that is optimized for growth will not offer you the best income benefits… and the contract geared to income, will not be the best growth option.
There are over 350 different index annuity contracts on the market today and it’s growing every day.
Far too many agents have one preferred contract they work with for all scenarios. That is just not appropriate, and it’s why we start by understanding your objectives before looking at a specific contract.
- Index annuities are perfect if you want safety and growth.
- ‘Hybrid’ index annuities with income riders are great for growth + income.
- The specific annuity contract that’s ideal for growth is not the best for Income…
- First, learn how they work in general, then give us a call to select the contract right for you.
How Do Fixed Index Annuities Work?
So lets dive in to see how the fixed index annuity works.
Fixed Index annuities are nothing more than fixed annuities with a different method of crediting interest. With a fixed annuity, the contract owner receives a stated rate of interest each year.
But with a fixed index annuity, the appreciation rate is calculated based on growth in an outside market index.
If the index goes up, the contract makes money. But if the index goes down, the principal is protected and the contract does not lose value.
Index annuities give consumers partial participation in the gains of the equity markets in exchange for principal guarantees.
Index annuity owners will not lose money no matter how badly the market performs. It is a place for safe money.
How Insurance Companies Make This Possible
How can insurance companies make a guarantee to go up, but not down?
It is not too good to be true, and it actually makes good sense once you see how it works. Let’s start with the structure of a traditional, plain old fixed annuity as that is easy to understand.
When you purchase a fixed annuity, you give the insurance company your premium and they essentially invest it in bonds and conservative vehicles like mortgages on commercial real estate. This is known as the insurance company’s ‘General Account’.
Whatever return the general account generates, less company operating expenses, equals the interest credit rate available for the annuity contract. The insurance company has all this calculated ahead of time and makes the fixed interest rate offer accordingly.
As an example, let’s assume an insurance company can make 6% return on investment and that annual operating expenses are 2%. In this case, a fixed annuity will be credited with 4% interest.
You’d buy a fixed annuity with a 4% guaranteed rate of return for a period of time (typically 3 to 10 years) and that’s exactly what you would receive.
Enter The Fixed Index Annuity
In a fixed index annuity, the insurance company takes your premium and invests the principal in the same type of bonds and mortgages as are in the safe and steady general account.
But with an indexed annuity, you have two basic options with the interest income. You can elect to take the base interest rate (which is roughly equivalent to the ‘general account’ and what a fixed annuity would pay) or you can opt for the possibility of more growth.
If you opt for more growth, the company uses the interest earned from the conservative portfolio to purchase an option position in a market index. An option is simply the right- but not the obligation- to purchase securities at a future date for a contractually stated price.
If the market goes up, the company will exercise the option and realize a gain. They credit a portion of the gain on that option contract to your annuity contract.
If the market moves sideways or down, the option expires worthless and no interest – or gain- is available for crediting.
The cost of the option position typically uses up your interest earnings for the year from the conservative underlying investments. So while the principal is safe and securely invested still, its earnings were used up by the option and thus, you have a flat year with no interest credited.
Potential for Gain with No Risk of Loss
Index annuities truly offer you the potential for gains based on market appreciation, without the risk of loss to your principal.
Your principal is not at risk, rather, it’s only the earnings from your principal are invested in potentially higher yield options. Thus, an indexed annuity is a safe asset with upside potential.
This explanation also gives you a good idea why these are called “Fixed Index Annuities”. Income from the FIXED account growth is used to buy options in a market INDEX for potential gain.
If the market rises, you may profit. If the market falls, the company has wagered only your income from the FIXED account, so your principal at all times remains safe.
Fixed Index Annuity Highlights:
An indexed annuity balances the safety of a fixed deferred contract with the potential for gains of a market based investment.
While historically it’s true that the stock market offers the potential for higher returns, that upside always comes with potential risk. Fixed index annuities offer a way for a conservative investor to safely use a fixed interest product that prioritizes safety and protection of principal, but achieve the potential for higher returns than traditional fixed investments.
Naturally, you give up some upside in exchange for the downside insurance, but overall they are a very good, safe money option.
Who the Fixed Index Annuity Is Right For:
Investors constantly wrestle these forces of security and yield in every individual investment and in each portfolio allocation decision.
An indexed annuity is a product that effectively produces gains for investors while minimizing risk. They truly do provide a middle ground where performance meets safety and investors can experience the best of both worlds.
Fixed index annuities are a very attractive annuity for many investors because the principal investment is protected and guaranteed from loss, while the potential for gains allows for some market participation without downside risk of loss. But pay attention to the details! Each indexed annuity offers different components and characteristics. Insurance companies vary:
- The minimum amount you are guaranteed to earn,
- The maximum amount you can earn,
- The total percentage of upward movement in an Index that you can participate in,
- The use of your accumulated funds once the annuity term is over.
For any fixed index annuity, it is important to clearly understand how the contract works, to ensure your selection is best suited to meet your future retirement needs. Be sure to read through our Fixed Index Annuity Report And Video Series for detailed information, guidance, and strategies for picking any indexed annuity product.
And remember, when a Fixed Index Annuity is coupled with a lifetime income rider, it’s typically referred to as a ‘Hybrid Annuity‘ and things can get more involved in understanding the suite of benefits. Please contact us for help understanding and selecting the best fixed index annuity for your situation.