Instead of providing a guaranteed interest rate like a fixed annuity, an indexed annuity offers the potential to earn higher interest rates. There is a trade-off though; the only guarantee is that you will never be credited less than zero percent.
Shopping for a fixed index annuity may seem overwhelming but it doesn’t have to. In our Ultimate Guide to Fixed Index Annuities, we will cover everything you’ll need to know to make an informed purchasing decision.
All annuity sales fall into one of three categories. The first thing you should do when considering a fixed index annuity is to decide what your objective is for this portion of your retirement savings. Is it:
1. If you are shopping for an annuity designed for accumulation it is best to stick with shorter duration contracts; we typically recommend 5 or 7 years or a combination of the two.
2. If it sounds too good to be true it probably is. There are some fixed index annuities that show a hypothetical average annual rate of returns of 9.5% net. The S&P has averaged 9.3% over its history and that is with unlimited downside risk.
Look at the inception date of the indexes inside of the index annuity. Most of the products that are trying to win a beauty contest with their hypotheticals are using indexes created within the last 12 months.
It is easy to create an index that backtests well over the last 10 years when you know exactly what happened over the last 10 years.
There is a difference between hypothetical backtesting and historical calculations. Historical means the index existed and hypothetical show return based on if the index actually existed.
I recommend selecting an indexed annuity that has a few competitive indexes and credit strategies. Each year on the contract anniversary new rates are determined and you have 30 days to re-allocate. If the cost of the option of your initial index increases during the contract year it is likely that your rates will be reduced. Multiple indexes hedge this risk as you can re-allocate to an option that is more favorable.
If an advisor tells you about a product he has been selling to all of his clients – don’t buy it – call me.
Fixed Index Annuities Designed for Lifetime Income
Don’t get caught up in the bells and whistles or smoke and mirrors. If you are shopping for an index annuity with a lifetime income rider the rollup rate, bonus, income value bonus, payout percents – none of them really matter.
You need to get an illustration ran specifically for you (and spouse if you have one).
The amount you should be most concerned with is the guaranteed lifetime income at the age you plan to begin monthly income payments. If you are not sure we can heat map the top payouts for the 5 years before and after your desired retirement age so you can select an annuity that is in the top 2 or 3 for all potential income begin dates.
Do you want guaranteed lifetime income that is higher or would you be open to taking a lower income initially with the potential to get performance-based income increases for the rest of your retirement?
What is a Fixed Index Annuity?
A fixed index annuity is a contract between you and an insurance company that may help you reach your long-term financial goals. In exchange for your premium payment, the insurance company provides you income, either starting immediately or at some time in the future.
NOTE: You may also hear of a fixed index annuity referred to as a:
Equity Indexed Annuity
Fixed Index Annuity Benefits
The primary benefits of an index annuity are tax deferral, the potential for higher interest rates, and principal protection from downturns in the financial markets.
Fixed index annuities provide an opportunity to earn higher interest rates than a fixed annuity, CD, or any other retirement savings vehicle that provides principal protection.
Long-term care riders and benefits are also available and can leverage your annuity account value by 300% for long-term care expenses.
In addition, as stated in the PPA of 2006, any gain in a nonqualified annuity will come out tax-free if used for long-term care expenses.
Under current federal income tax law, any interest earned in your fixed index annuity contract is tax-deferred. You don’t have to pay income taxes on any of your gains until you begin receiving money from your contract.
Withdrawals are taxed as ordinary income and, if taken prior to age 59½, a 10% federal additional tax may apply.
The below chart shows how tax-deferral can impact the value of an indexed annuity over time. The chart assumes a $100,000 index annuity grows at 4% compounded annually and compares the index annuity’s account value 20 years later with and without tax-deferral.
As you’ll notice the index annuity growing tax-deferred for 20 years has a value of $10,000 greater than a taxable investment.
Disclosure: This example assumes a 33% ordinary income tax assessed annually on taxable earnings and at the period ending on indexed annuity tax-deferred earnings. Actual tax rates may vary from this example for different taxpayers and assets (e.g., capital gains and qualified dividend income). The actual performance of your contract will also vary.
Hypothetical interest is not guaranteed and does not represent the performance of any particular index annuity. If a withdrawal or distribution is taken, the tax-deferred earnings would be reduced by income taxes on any interest and, if taken prior to age 59½, a 10% IRS tax penalty may apply. Consider your personal retirement plan and income tax brackets, both current and anticipated, when making financial decisions.
Fixed index annuities provide an opportunity for potential interest growth based on changes in one or more indexes. Because of this potential indexed interest, FIAs provide a unique opportunity for accumulation.
And since the interest your contract earns is tax-deferred, it may accumulate assets faster. In addition to potential indexed interest, FIAs can offer you an option to receive fixed interest.
Fixed index annuities offer you a level of protection you may find reassuring. That protection can benefit you in three separate ways:
• Accumulation: Your principal and credited interest are protected against market downturns. • Guaranteed income: You can be protected from the possibility of outliving your assets. • Death benefit: If you pass away before annuity payments begin, a fixed index annuity may help you provide for your loved ones.
When you purchase a fixed index annuity, you can allocate its value to one or more chosen indexes. At your index annuity’s contract anniversary the performance of your selected index is measured and one of the index annuity crediting methods is applied to determine how much interest will be credited to your annuity for that contract year.
Step #1: Determine the market index’s annual performance.
Step #2. Apply the crediting method applicable to your index annuity.
If the stock market index performs your index annuity will automatically be credited interest, subject to a participation rate, a cap, or spread. Interest credited to an index annuity is locked in annually, and cannot be lost due to any future stock market index declines.
The annual lock-in and annual reset feature are two huge benefits of an index annuity and they are not talked about enough.
Annual lock-in: Your account value is locked in every year at your anniversary. This means once you’ve earned interest you can not lose it due to market volatility. It is not a number on a piece of paper (401k) it is real money.
This also means your death benefit is locked in because your account value is the death benefit (unlike variable annuities without an optional death benefit rider).
Annual Reset: This means the starting value used to measure the stock market index performance resets every year. So in a year where an index is down 30% your account value remains flat because it is “locked-in”; however, your new starting point will be the index value 30% below the previous starting point.
Determine the Market Index Performance
The annual point-to-point indexed annuity crediting method compares index values from two points in time; your contract issue date and the annual anniversary. If the result is positive, interest is credited, subject to the cap, spread, or participation rate. If the result is negative, the credited interest rate is 0%.
The below graph shows a hypothetical index value change from 100,000 on contract issue to 107,000 on contract anniversary. This represents an annual index performance of 7%.
The line graph below compares the sales of variable annuities (VA) and fixed index annuities (FIA) in the United States from 2006 to 2020. Variable annuities are represented by the blue line while the red line represents indexed annuity sales.
As you can see, variable annuities have decreased in popularity significantly while fixed index annuities are becoming increasingly popular. VA sales decreased from approximately $185 Billion in 2006 to ~$100 Billion in 2020 while FIA sales increased from ~$75 Billion to ~$120 Billion during the same timeframe.
2016 marked the first year that individual fixed index annuity sales surpassed variable annuity sales in the United States. This is due in large part to the high cost and fees associate with variable annuities vs. low or no fees of an index annuity.
Typical Variable Annuity Fees
M&E (mortality and expense) – average around .50%
Sub-Account Fees – average 1.00%
Optional Rider Fees (income rider or death benefit rider) – Average 1.00% each
Typical Index Annuity Fees
No Fees for Base Index Annuity
Optional Indexed Annuity Rider Fees – Average 1.00%
An indexed annuity’s credited interest is calculated annually and determined by the performance of a specified stock market index. However, you are not directly invested in the market which means your index annuity account value won’t decrease due to a potential market downturn.
10% Free Withdrawals
Annual free withdrawals up to 10% of your index annuity’s account value annually without penalty.
Interest Only Free Withdrawals
Withdraw your index annuity’s accumulated interest annually without penalty.
Extended Care Waiver Rider
If you are confined to a nursing home or long-term care facility for at least 90 consecutive days (after the first contract year), this waiver provides you with the option to withdraw 100% of your index annuity’s account value without penalty.
Terminal Illness Rider
After the first contract year, if you are diagnosed by a physician as having a terminal illness, you have the option to withdraw up to 100% of your indexed annuity’s value without penalty.
Our Annuity Terms Glossary has a comprehensive list of index annuity terms and definitions written in plain English.
I spent the first 10 years of my career as a clinical mental health therapist and I saw firsthand that finances play a large role in one’s happiness.
A good financial plan is not only important to your financial health it’s also important to your mental health.
I approach financial planning from a behavioral finance perspective using a goals-based approach. Kiara holds a B.A. Degree in Psychology from Goshen College and an M.A. in Clinical Mental Health Counseling from Valparaiso University.
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