Earnings on some deferred annuities are linked to stock market performance.
If you can’t decide between a fixed and a variable annuity, or if you’re uneasy about investing directly in the stock market, you may want to investigate a fixed index annuity.
Fixed index annuities earn interest at a rate determined in part by the performance of a specific stock market index, often the S&P 500, not including dividends. If the index gains value during the specific time period set in the contract, your indexed account is credited with a return that’s linked to that gain. This provides an opportunity for your account value to grow. If, on the other hand, the index loses value in the specified period, as it may do, your indexed account is credited with 0% interest rather than a negative return.
Understanding the appeal
By protecting your principal against market downturns, the issuer of a fixed index annuity insulates you against market volatility — provided, however, that you hold your annuity for the index period during which you’re accumulating interest. That period is often 10 years from the date you sign the contract though it may be as short as 5 years or as long as 15.
But if you surrender your contract before the end of the index period, two things happen. You pay a surrender fee, which may be 10% of your premium or higher in the first year and typically drops one percentage point each year until it disappears. In addition, what you’re repaid is the guaranteed minimum account value of your account. That’s typically 87.5% of your premium plus any interest that has accumulated. Some but not all contracts have a guaranteed minimum rate.
As with other fixed annuities, the contract guarantees are backed by the issuer’s ability to meet its financial obligations.
Computing the interest
The contract you make with the annuity issuer will explain the indexing features it uses to calculate the interest that’s added to your account. In most cases, there’s some combination of a participation rate, a spread or margin, and a cap.
- A participation rate determines what percentage of the index gain will be credited, typically in a range from 50% to 100% or sometimes more. So, if the rate was 85% and the index gain was 10%, 8.5% of the gain would be credited.
- A spread or margin is a percentage that is subtracted from the gain to determine what will be credited. So if the margin was 4% and the gain 10%, 6% of the gain would be credited.
- A cap is the maximum rate that will be credited whatever the index gain is. For example, with a 3% cap, you would be credited with a 3% return whether the index return was 3% or 30%. However, if the index rose less than the cap, say 2%, your account would be credited with a 2% gain.
The various rates can be adjusted, up or down, at the issuer’s discretion during the accumulation period. If more than one factor is used, as is often the case, the one that results in the lowest credited rate takes precedence.
Issuers can use several methods to identify the change in the index, which is the primary factor in determining the interest to be credited to their contracts. A key difference is where the start and end points that book-end the change are set. Because you choose the crediting strategy for your account and can change strategies annually or bi-annually, it’s smart to investigate how each of the approaches works.
The calculation may be done each month or each year, with any potential gain credited to your account. Or the calculation may be done only once, at the end of the annuity’s term. In that case, it is the difference between the index levels on the days that start and end the index period that determines your return.
What to consider
You may have good reasons to add a tax-deferred fixed index annuity to your portfolio, provided you are confident you can hold your contract for the full accumulation period and so avoid surrender charges and potential loss of principal.
Your accumulated contract value can be a source of retirement income, either because you annuitize or you purchase a rider for an additional fee that gives you the right to a guaranteed lifetime income benefit. The amount you receive each year for your lifetime will be fixed at the time the payout period begins.
But you’ll also want to remember that indexed annuities are complex products. Among other things, contract terms vary from provider to provider as well as among contracts from the same provider. That can make it difficult to compare contracts to each other or to other approaches to achieving a comparable return at a similar level of market risk.
Why Fixed Index Annuities Can Be Beneficial For You? by Inna Rosputnia
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