What is an Annuity?
Before we answer the question, “What is a fixed index annuity (FIA)? ” Let’s start off with a recap for any newcomers looking to know more about annuities. An annuity is basically a contract between you and an insurance company. You pay for the annuity either in a single lump sum or multiple payments over time and in return the insurance company promises to pay you money from the annuity in a single payment or a series of payments.
Like many other long-term financial products (i.e. CDs. IRAs. and 401(k)s ), annuities have a surrender fee for early withdrawal; the terms of which depend on your contract. There are two main types of annuities, fixed annuities (or fixed index annuity) and variable annuities. With variable annuities. the consumer assumes the risk for the annuity’s value and with fixed annuities (or fixed index annuities), the insurance company assumes the risk.
What is a Fixed Annuity?
Now, digging a little deeper, let’s talk about what a fixed annuity is. A fixed annuity is a contract between you and an insurance company that offers you a fixed rate of interest on your investment. It is typically invested in lower risk fixed income product such as government securities and corporate bonds . Fixed annuities earn steady or “fixed” interest for a specified period of time, usually one to ten years. Fixed annuities also protect your money from the drama of the stock market, and are also considered to be one of the safest investments available, especially when the stock market is volatile.
Another popular feature with a fixed annuity (and variable annuity) is the ability to defer taxes on gains until the annuity is withdrawn. This is probably the most significant difference between a CD, where the gains are taxed every year and an annuity, where the gains are not taxed until the annuity is surrendered .
What is a Fixed Index Annuity?
Now let’s talk about fixed index annuities. If you want the safety of a fixed annuity with the potential for better long term growth, a fixed index annuity may be of interest to you. What makes fixed index annuities interesting is that they provide the same type of protection as a traditional fixed annuity along with the potential for higher interest based on positive changes in an external index, like the S&P 500 or Barclays US Dynamic Balance Index. However, you are not actually participating in the market and there are limits to how much interest you may earn. In other words, a fixed index annuity offers the protection of a fixed annuity with more upside potential if there are gains within the index you have chosen.
Fixed indexed annuities have a distinct way of calculating annual interest using a formula based on changes in the performance of the stock, bond, or commodity index. The index is used as an external benchmark that you’re not actually investing in. The interest you earn and when you receive it depend on the features of your particular contract. Generally, fixed index annuities have an interest-rate floor, a participation rate. and a cap that determine the amount of interest you can earn. Your interest rates always remain somewhere between the floor and the cap. They do not rise above the cap even if the index goes higher. Conversely they never fall below zero, even if the index falls dramatically. This is why fixed index annuities are considered such a safe investment and why they became so popular during the 2008-2009 crisis.
Basically, the value of your money will never decline as long
as it is in the annuity, but it can increase with the rising index. Once the interest is credited it can never be lost due to interest rate adjustments or negative market fluctuations, but it may even compound. This means more potential growth than fixed annuities and simple savings plans, and less risk than variable annuities and other volatile investments. Ultimately an fixed index annuity could bring some balance to your retirement plan.
The process of choosing an index can also give you peace of mind. These financial products are backed by some of the world’s largest, most reputable insurance companies and can only be sold by licensed insurance professionals who are mandated to receive specific product training. Companies are required by their states’ insurance department to ensure that every annuity sale is suitable for the customer’s age, financial situation, and goals. These requirements are put in force by each insurance company’s suitability department. And while agents are paid commissions, no sales compensation is ever deducted from your annuity’s principle.
There are 12 areas of suitability requirements . Agents must have “reasonable grounds” to believe that the annuity recommendation is suitable based on these 12 areas disclosed by the investor: Age, Tax status, Intended purpose of the annuity, Financial time horizon, Existing assets, Source of funds, Other insurance and annuity products, Investment objectives, Liquidity needs, Liquid net worth, and Risk tolerance.
How Safe Are Fixed Index Annuities?
In 2008 and 2009, Americans lost an unprecedented amount of retirement savings because of stock market volatility. As many investors lost substantial amounts of money during the financial crisis, millions of people holding fixed index annuities found themselves relieved that their annuity did what it was supposed to do. It protected them from the crisis and saved all or at least that part of their retirement plan. Those with indexed annuities lost nothing . During the financial crisis, so many people started investing into fixed index annuities that many of the insurance companies actually stopped taking new clients.
Overall, fixed index annuities are one of the safest annuities that you can invest your hard earned money into, and expect it to be safe from the drama of the stock market.
What is a Variable Annuity?
I also want to quickly mention variable annuities. A variable annuity, as I said earlier, is somewhat riskier than a fixed or fixed index annuity simply because the risk of the underlying investment is held by the individual investor. The investments are placed in subaccounts that are managed by fund managers rather than by the insurance company. The biggest thing you should consider before buying a variable annuity are the fees such as follows: the mortality and expense ratio, death benefit riders, income riders, subaccount fees, etc. I have seen some fees as high as 5% per year. I am not advocating against variable annuities as there have been great returns in these products over the last few years, however one should make themselves aware of the cost before signing the contract. Click the link for our previous article on variable annuities .
There a lots of great fixed index annuities out there and we would love to help you find the best option for your specific needs. That’s why you should take the 60 second challenge! With our proprietary retirement calculator, we will compare over 40 annuities in under 60 seconds based one your age, deferment, and what you want to invest. Our goal is to help you to make an informed decision and save you from commission junkie, insurance agents. So, if you have any questions please feel free to email us .