What are they? How do they work?
Without stating the obvious parts relating to annuities in general, indexed fixed annuities are a relatively new way to invest your money in an annuity product. (Read this first if you need the basics of annuities explained to you). They are new to the market in the sense that fixed annuities have been around for well over a century, but old enough that there are thousands of products available through a wide-range of different carriers.
This type of annuity, also referred to as an equity-indexed annuity, has become quite popular within the retirement investing circles. Although touted as the be-all-end-all of annuity contracts, the indexed annuity is not without its weaknesses.
Don't get us wrong, in theory, the product is beautiful. It combines the classic elements of a fixed annuity contract with the growth benefits of a variable annuity. Proponents suggest that this is as close to risk-free gains as you are going to find in an investment vehicle.
Fixed indexed annuities are designed to provide a guaranteed minimum rate of return on your money. This return is given regardless of how the market performs. In addition to the guaranteed minimum rate, the annuity will also provide the investor the ability to participate in market growth of an underlying market index.
The fixed index annuity is designed to protect your investment from market downswings, providing minimum rates in such years. Further, you are provided growth potential when the market grows, increasing your rate of return in the annuity. The combination of downside protection and upside potential make this type of annuity an easy sell for advisors. Before you jump on the bandwagon however, you should understand a couple of key features of this complicated product.
Indexing Options For An Indexed Fixed Annuity
The first thing to understand with an indexed fixed annuity is that you are not going to get the full amount of market growth from the index. The insurance companies have built into the product a way to protect themselves from the risk of providing a minimum guaranteed rate. Your annuity will in one form or another have a cap, spread, participation rate, or margin. Without getting into details (we do elsewhere on the website), each of these limit the amount of growth credited to your account.
A participation rate of 60% for instance, would allow you to participate in 60% of the growth of the index. If it increased by $100, you would get credited $60 of it. The other options function in a similar sort of way, and limit the upward growth of the account.
What To Watch For
Before you jump out and purchase one of these fixed indexed annuities, you should also be aware of a couple more points that advisors don't particularly highlight in their sales pitch. We talked about the first briefly. As long as you don't expect to receive the full gains of the market growth, you should be fine. Just understand how your account is credited.
On a related note, some annuity contracts have a provision built in that allows the annuity company to change the participation rate or cap from year to year. If this is the case, it can be very difficult to estimate how the product will perform in the future. Look for a product that guarantees these rates.
Another important feature of many of these contracts is that the minimum guaranteed rate may not cover the entire value of the annuity. Many contracts will only guarantee a percentage (90%) of the contract. This is generally only a problem if you do not intend to hold the contract for more than a couple years however.
The other warnings are pretty typical for annuities. Surrender charges and early termination fees can wreak havoc on your account values. Make sure you are in for the long-term on any type of annuity contract. Also, withdrawals before age 59 1/2 will also incur a 10% tax liability on the withdrawal.
Are fixed indexed annuities really risk-free? Can you still lose money?
So...when you advisor tells you that the indexed fixed annuity is risk-free, are they right? No, not entirely. Although the indexed annuity offers some unique features, if you are unwise with how you go about the contract, you can in fact lose money.
Does that mean you shouldn't look into one? Absolutely not. These can be a great way for investors to combine the security of a fixed annuity with the growth potential of variable annuities. Before you jump into a contract, make sure you look at the different indexed fixed annuity rates available for your circumstances. You may find that this type of contract is exactly what you have been looking for. As with any financial product, make sure you fully understand what you are purchasing and get good advice on any decision you make.