Fixed Index Annuity Pros and Cons
Fixed index annuities, sometimes referred to as equity-indexed annuities, have become increasingly popular in recent years. As a result, more annuity companies are now issuing fixed index annuity contracts. Deciding which insurance company has the best annuity to meet your individual goals and objectives seems overwhelming.
This guide will walk through many of the pros and cons of fixed index annuity benefits as well as fixed index annuities.
What is a Fixed Index Annuity?
Watch a Video: What is a fixed index annuity? (3 mins 51 seconds).
A fixed index annuity is a type of fixed annuity. It credits interest based on the performance of an external market index rather than a guaranteed annuity rate.
An indexed annuity offers the opportunity to earn more interest when the markets perform. It also provides downside protection from a potential market downturn
NOTE: You may also hear fixed index annuities referred to as:
- Equity Indexed
- Hybrid Annuity
- Indexed Annuity
The below infographic illustrates where a fixed index annuity falls between a fixed annuity and variable annuity as well as other investment vehicles on the investment continuum.
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How Do Fixed Index Annuities Work?
Fixed Index annuities earn interest-based, in part, on the positive performance of an external stock market index, such as the S&P 500®.
Interest is credited to an index annuity on each contract anniversary and is guaranteed to never be less than zero percent.
You are not investing directly in the stock market so you can not lose money in a fixed index annuity even if the stock market crashes.
Crediting Methods and factors are then applied to the index performance to determine your interest rate.
Applying Indexed Annuity Crediting Factors
There are three fixed index annuity crediting methods available in index annuities:
- Spread (Assume 2%)- index’s increase (7%) – spread (2%) = 5% interest earned.
- Cap – (Assume 5%) 100% of the index’s increase (7%) up to the cap(5%) = 5% interest earned.
- Participation Rate – (Assume 50%) The index’s increase is 7% X (50%) = 3.50% (the participation rate) = interest earned.
Annual Point to Point Crediting Method
Many equity indexed annuities use Annual point-to-point uses the index value from only two points in time making it simple and straightforward to calculate.
Calculating index performance using the annual point-to-point method:
- Subtract the index at the end of the term from the value at the beginning of the term.
- If you have a positive number then the index has performed and you divide it by the starting value to get the percent increase.
Step #1: 107,000(end) – 100,000(initial) = 7,000 positive changes in the index value.
Step #2: 7,000 (end) / 100,000(initial) = 7% index performance.
Stock Market Indexes available in Fixed indexed annuity Products
Fixed Index Annuity vs Variable Annuity
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. This is partly because variable annuities have more fees than any other annuity type.
Variable annuity sales have decreased from approximately $185 Billion in 2006 to ~$100 Billion in 2020. Equity-indexed annuities increased from ~$75 Billion to ~$120 Billion in sales.
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 associated with variable annuities vs. the low or no fees of an index annuity.
Typical Variable Annuity Product Fees
- M&E (mortality and expense) – average around .50%
- Sub-Account Fees – average 1.00%
- Optional Rider Fees (annuity income rider or death benefit rider) – Average 1.00% each
FINRA Indexed Annuity Investor Alert
For a thorough breakdown of Fixed Index Annuity advantages and disadvantages, we suggest reading FINRA’s Investor Alert: Equity Index Annuities: A Complex Choice.
In Summary: Fixed Indexed Annuity Pros & Cons
- Index annuity account balances are “locked-in” annually.
- May provide a better rate of return than other investments with principal protection.
- Annuity investors are able to grow their retirement savings tax-deferred.
- An index annuity yields a better rate of return when the stock market performs.
- Optional lifetime annuity income riders are available on many index annuity products.
- Backed by state-regulated insurance companies with strong financial ratings.
- You can make unlimited contributions; unlike an IRA or 401(k).
- A 10% IRS Penalty Applies to Index Annuity Withdrawals Prior to 59 1/2
- Fixed Index Annuity gains are taxed as ordinary income, not the lower capital gains tax rate like many other investments.
- Some of the optional annuity income riders come with annuity fees charged as a percent of your account annually.
- Indexed annuities come with charge a fee on withdrawals above the free withdrawal amount (so do many annuity contracts).
- The interest you can earn in an Index Annuity is limited by an index annuity crediting method so there is less upside potential than in riskier investment options.
- The vast variety of Index Annuity products and features can be confusing and at times seem overwhelming.
- Annuity Companies can your annuity’s interest crediting rates at each contract anniversary.
Is an Index Annuity Right for You?
There are multiple annuity products so I wanted to wrap up my fixed index annuity pros and cons guide with some helpful tips on how to decide if a fixed index annuity may be a good investment for you.
An Index Annuity may be right for you if…
- You have a retirement plan in place with equity components, but want to diversify with low-risk annuities.
- You want a generate a steady stream of guaranteed annuity income.
- You want the chance to earn more interest than you would if you bought another type of fixed annuity product.
- You have maxed out your 401(k) and traditional IRAs and want to contribute more to tax-deferred investments.
- You are approaching or already retired and need to minimize the sequence of returns risk.
An Index Annuity may not be right for you if…
- You are very comfortable with risk and fluctuations in your portfolio balance.
- You have already incorporated enough fixed-income solutions that hedge against market volatility into your retirement portfolio.
- You anticipate you may need to the cash in your annuity before the full term of the contract or before you reach age 59 1/2.
- You are behind on your retirement savings and really need to invest in riskier assets in an attempt to make up for lost time with higher gains.
Frequently Asked Index Annuity Questions
How often can you reallocate index strategies?
You may reallocate available funds at the end of each crediting period on your contract anniversary. You have 30 days to submit a re-allocation form and if you do nothing your allocations will remain the same as the previous year.
Are fixed index annuities a good investment?
It is important to note that a fixed index annuity is an insurance contract issued by an insurance company and is not a security. As such, they will not generate equity-like returns.
They are a good retirement savings vehicle that provides a safe and steady way to grow your retirement savings.
Can You Loose Money in a Fixed Index Annuity?
You can not lose money in a fixed index annuity due to a potential stock market crash. A fixed index annuity can only decrease in value due to withdrawals or fees for optional riders.
Does a Fixed Index Annuity have any fees?
Fixed Index Annuities do not have any fees in general; however, there are optional income riders, long term care riders, and death benefit riders that can be added to an index annuity for a fee.
What are the disadvantages of a fixed index annuity?
- Gains are limited by a crediting method or “limiting factor”
- Fixed index annuity contracts can be complex and difficult to compare
- Indexed annuity contracts vary greatly from insurance company to company
- They are highly customizable and typically require an experts assistance
- Surrender penalties for withdrawals above the annual free withdrawal provision
- Potential 10% IRS tax penalty for withdrawals prior to age 59 ½
- Interest crediting factors (cap, participation rate and spreads) can change on the contract anniversary date.
What is an Uncapped Index Annuity?
An Uncapped Fixed Index Annuity refers to an indexed annuity with a crediting method that does not cap the interest your account can be credited in any given year. Instead of a cap, uncapped options use a spread or participation rate crediting method.