Fixed Indexed Annuities
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Key Takeaways
- Fixed Index Annuities provide a unique balance of potential market-linked gains with principal protection, making them a favored choice for securing retirement finances.
- Understanding the features and indexing methods associated with Fixed Index Annuities is crucial to maximize the benefits and tailor them to your financial goals.
- While Fixed Index Annuities offer enticing bonuses and benefits, it's essential to carefully consider associated fees and surrender charges to ensure they align with your long-term financial strategy.
- Before committing to an Annuity, assess your risk tolerance, income needs, and desired flexibility, as these factors play a significant role in determining whether a Fixed Index Annuity is the right choice for your financial future.
Definition of Fixed Index Annuity
A Fixed Index Annuity also known as a "hybrid annuity" is tied to a common market index, such as the S&P 500, Dow Jones, or Russell 2000 and many more. Your annuity earns gains when the index rises and is performing well. And even if the index declines in value, your account is protected and cannot lose value. This is what makes a fixed index annuity the preferred financial vehicle for securing retirement. You can enjoy the gains of the stock market without the market risk and no risk to your principal.
The insurance company that issues your annuity will assume the market risk, and will provide a return when the index linked to your contract is positive. The gains you earn on your annuity are 'locked in' every year, and your account value can never decrease. Your principal is guaranteed to grow at a pre-determined rate in case the stock market has a down year and does not perform well. Annuity rates on fixed index annuities are usually substantially higher over fixed rate annuity returns and other retirement financial vehicles.
Fixed Index Annuities Features
Many Benefits Of Fixed Rate Annuities
Including guaranteed lifetime income, Substantial and Solid Returns and Inheritance Options.
Market Linked Gains
Linked to a stock market index, like the S&P 500, Dow Jones, etc., you have the potential for higher returns. These annuity return rates outperform CDs and debt-based vehicles like bonds in the long-term.
Protection of Principal
Your account will never lose value no matter how much the market drops in a given year.
Guaranteed Rate
A minimum guaranteed fixed interest rate provides protection of your money in the event of consistent market losses.
Power of Tax Deferral
Pay nothing on interest earned until you start taking withdrawals.
Estate Planning
Avoid the delay and cost of probate with direct payment to your designated beneficiary(ies).
During the accumulation period of a Deferred Fixed Index Annuity, the rate of return on your account depends on the market index you choose. Although the value of any index varies from day to day and isn't predictable, the insurance company guarantees the value of your annuity will not decrease as long as you do not withdraw the money.
How Are Fixed Indexed Annuities Different From Fixed Annuities?
A Fixed Indexed Annuity is different from Fixed Annuities. Fixed rate Annuities credit a fixed rate of interest, which the insurance company guarantees. Indexed Annuities credit interest using a formula based on changes in the performance of an equity, bond or commodity index. This formula determines how the interest, if any, is calculated and credited to your Annuity's account value. The features of your particular Fixed Indexed Annuity will define the amount of interest you receive and when it is applied.
An Indexed Annuity also offers a guarantee. A declared minimum interest rate will be credited on part of your initial premium if you decide to surrender the Annuity or if your Annuity linked index performs poorly. This guarantee is not credited annually. It's important to note that if there's a negative change in the index your Annuity is linked to, your Indexed Annuity will be credited with 0% interest, and will never be credited with a negative return.
For example, some Indexed Annuities guarantee the minimum value of your Annuity will never be less than 87.5% of the premiums you've paid, plus at least 3% interest (less any partial withdrawals). You will never receive less than the guaranteed minimum value, even if you surrender your Annuity, withdraw the full amount and pay surrender fees. An Indexed Annuity with a minimum guaranteed surrender value of 87.5% of premiums credited with 3% interest would provide a return of 101.43% at the end of a six-year term [(87.5% x 1.03%) x 5)] and more for longer term periods. However, if you decided to surrender such an Annuity before the fifth year, you would receive less than the premiums paid for the contract.
Floor on Index-Linked Interest
The floor is the minimum interest rate you'll earn on an Annuity. All Indexed Annuities have a floor of 0%. Having a 0% floor protects your Annuity account value from the risk of market downturns. So even if the index decreases in value, the index-linked interest you earn will never be negative adjustment to your Annuity's account value.
What Features Affect Interest Credited To My Annuity?
There are several different features on your annuity contract that you can select, that will affect your annuity's potential to earn interest. These features are the Index, Indexing method, Index term, Participation Rate and/or cap/spread rates, and bonuses. These features have the greatest effect on the amount of interest your Indexed Annuity is credited with. It's important to understand these features and how they work together.
The Index
Indexed Annuities credit interest using a formula based on changes in the performance of an equity, bond or commodity index. The index is an external benchmark. The Annuity isn’t invested directly in the investment that’s the basis for the index. For example, if the Annuity is linked to a stock fund you aren't buying shares of stock and dividends paid on stocks don't increase your Annuity earnings. The company credits earnings to your Annuity based on the index you select, but guarantees the value of your Annuity won’t decrease because the index goes down. Note that the past performance of an index doesn’t indicate future results. Some Annuities may be linked to more than one index.
Indexing Method
The indexing method is the way the amount of positive change, if any, in the index is measured. Some of the most common indexing methods, which are explained more fully later on, include annual point-to-point, term end point and monthly and daily averaging.
Index Term
The index term is the period over which index-linked interest is calculated; the interest is credited to your Annuity at the end of a term. Terms are generally from one to ten years, with one year being the most common. Some Annuities offer a single term while others offer multiple, consecutive terms because of multiple crediting strategy options. For Flexible Premium Annuities, the payment of each premium may begin a new term for that premium. An Annuity that credits index-linked interest less often than annually may credit none of the index-linked interest, or only part of it, if you take out money before the end of the term. It’s important to understand how this will affect you if you’ll be making a full or partial withdrawal before the term ends.
Participation Rate
The participation rate determines how much of the increase in the index will be used to calculate index-linked interest. For example, if the calculated change in the index is 9% and the participation rate is 70%, the index-linked interest rate for your Annuity will be 6.3% (9% x 70% = 6.3%.)
The company usually offers a participation rate for a specific period (from one year to the entire term.) When that period is over, the company can set a new participation rate for the next period. Some Annuities guarantee that the participation rate will never be lower than a set minimum or higher than a set maximum. It’s common for companies to offer participation rates of less than 100%, particularly when there’s no cap rate.
Cap Rate
Many Annuities may put an upper limit, or cap, on the index-linked interest rate. This is the maximum rate of interest the Annuity will earn. In the example given above, if a contract had a 6% cap rate, then 6% would be credited, not 6.3%. Some Annuities guarantee that the cap rate will never be lower than a set minimum or higher than a set maximum. It’s common for companies to use a cap rate, especially if the participation rate is 100%.
Spread Rate
In some Annuities, the index-linked interest rate is computed by subtracting a specific percentage from any calculated change in the index. This spread rate, sometimes referred to as the “margin” or “asset fee,” might be instead of, or in addition to, a cap or participation rate. In the example given above, if the calculated change in the index is 9% and the spread rate is 2.25%, the credited rate would be 6.75% (9% - 2.25% = 6.75%). In this example, the company subtracts the percentage only if the change in the index is positive.
Bonuses
Some Indexed Annuities offer a bonus. The most common type of bonus is a premium bonus. This type of bonus immediately increases the value of the Annuity and is usually credited as a percentage of the premiums paid into the contract. In some Annuities, there’s a separate charge for the premium bonus. This lets the insurance company keep the surrender charges lower, relative to other Annuities with a bonus. However, if you withdraw more than your penalty-free amount on such an Annuity, you may lose part of your premium bonus. This type of bonus is accessible to you if you decide to surrender your contract.
Another type of bonus is a Guaranteed Lifetime Withdrawal Benefit (GLWB) bonus. A GLWB bonus is like a premium bonus in that it’s usually a percentage of the premiums paid into the contract. However, a GLWB bonus is different in that you can’t access the bonus if you surrender your Annuity for cash. A GLWB bonus is credited to the benefit base value, not the accumulation value. For this reason, this type of bonus is only accessible if you take lifetime income payments through your GLWB.
The last type of bonus available on some Annuities is an Annuitization bonus. This type of bonus is very similar to a GLWB bonus but is only accessible if you take lifetime income payments through Annuitization. Many two-tiered Annuities offer this type of bonus.
When considering bonus options, it is important to know that although, bonuses can help boost your Annuity's account value, in general, Annuities with bonuses have higher surrender charges and the surrender charges apply longer than Annuities without bonuses. In addition, all things being equal, an Annuity with a bonus may have less potential for gains than a non-bonus Annuity. It is essential to be aware of the terms and conditions of any bonuses you're considering.
What Are The Features And Trade-Offs Of Different Indexing Methods?
| Features | Trade-Offs |
|---|---|
| Annual Point-to-Point | |
| The value of the index is reviewed on each policy anniversary. The change in the index is measured this way from one year to the next. Any interest earned is credited to your Annuity each year, subject to any participation, cap or spread rates. Since the interest earned is "locked in" annually and the index value is "reset" at the end of each year, future decreases in the index won't affect the interest you've already earned. | Only the beginning and end points are considered. Since potential interest is credited annually, your Annuity's participation, cap and spread rates may change each year and generally will be lower than that of other indexing methods. |
| Term End Point (also called Multi-Year Point to Point) | |
| Any index-linked interest earned is calculated on the difference between the index value at the end of the index term and the index value at the start of the term. Index terms may range from 3 to 10 years. Potential interest is added to your Annuity at the end of the index term as opposed to each year, subject to any participation, cap or spread rates. | Only the beginning and end points are considered. Since interest isn't credited until the term ends, you may not receive index-linked interest until the end of the term. There may be a lower spread rate or higher participation or cap rate than with some other indexing methods. Partial or full surrenders may not receive any index-linked interest if taken before the term ends. |
| Monthly or Daily Averaging | |
| Any index-linked interest earned is calculated on the difference between the index value at the end of the index term and the index value at the start of the term. Index terms may range from 3 to 10 years. Potential interest is added to your Annuity at the end of the index term as opposed to each year, subject to any participation, cap or spread rates. | In a steady-rising market, point-to-point methods may perform better. Since potential interest is credited annually, your Annuity's participation, cap and spread rates may change each year. Most products that use this indexing method lock in interest annually and reset the index value at the end of each year. This protects interest earned from being affected by future decreases. Participation and cap rates may be higher (and any spread rates may be lower) than with other indexing methods. |
| Monthly Point-to-Point | |
| Similar to monthly averaging, any index-linked interest earned is determined by comparing the change in an index's value from one monthly anniversary to the next monthly anniversary. Each month, positive changes are subject to the cap rate but negative changes are not. At the end of the term, the monthly changes are added and any positive index-linked interest is credited. If the sum is negative, zero interest is credited. | Contracts with this design have a lower cap rate than other designs because the cap rate is applied monthly, although interest is credited at the end of the term. Monthly decreases in the index will reduce any interest credited at the end of the term. Since this indexing method considers downward movements of the index, Annuities using this indexing method may earn higher index-linked interest than many other indexing methods in a steadily-rising market, due to cumulative increases in the index. |
Are There any Fees in Buying an Annuity?
Annuities have fees associated to the cost of selling and management. Fees are covered by deducting them directly from the contract value, or they may be reflected in lower interest rates.
There are no up-front costs when purchasing Fixed-Indexed Annuities. When adding a benefit rider to your annuity, there may be a charge based on the Annuity's accumulation value to cover the cost of the rider. Some Indexed Annuities may also charge a fee (based on the Annuity's accumulation value) to cover the cost of the crediting strategy used, rather than apply a cap, participation or spread rates. It is important to read the disclosure and ask your financial agent or the annuity company to disclose the costs that may apply to your Annuity.
Examples of Annuity fees and taxes
- A contract fee is a flat dollar amount charged either once or annually.
- A transaction fee is a charge for each premium payment or other transaction.
- A percentage of premium charge is a charge deducted from each premium paid. The percentage may vary over time.
- Some states charge a premium tax on Annuities. The insurance company pays this tax to the state. The company may subtract the amount of the tax when you pay your premium, when you withdraw your contract value, when you start to receive income payments or when it pays a death benefit to your beneficiary.
Surrender Charges
A surrender charge is usually a percentage of the premiums you've paid or of the value of the account when you make the withdrawal. You may pay this charge in order to take all or part of your money out at any time during your Annuity's accumulation period. Your annuity's contract and disclosure statement, will specify exactly the percentage of money you may withdraw without paying any fees, and when the charges will no longer apply, based on the timeframe you've had the annuity.
Some annuities have a penalty-free withdrawal feature. This feature allows you to make one or more withdrawals without a charge. up to a total percentage of your Annuity's accumulation value. If you make a larger withdrawal, you pay a withdrawal charge called a partial surrender charge. You may lose any interest above the minimum guaranteed rate on the amount withdrawn, and you may lose part of your principal.
What Optional Benefits Can I Choose?
Insurance companies offer many optional benefits that can be added to your Annuity. Some commonly offered riders are described below. Each rider will increase the cost of your Annuity. It is important to be aware of the cost associated with each rider, to determine if the rider would be beneficial to your situation.
Guaranteed Minimum Death Benefit
A Guaranteed Minimum Death Benefit rider guarantees the minimum amount of the death benefit the insurer will pay your beneficiary if you die before the insurer starts to make monthly payments to you. The insurer will make this payment regardless of the return on the investments in your subaccounts. For example, suppose you’ve paid $50,000 in premiums for a Variable Annuity and buy a rider that guarantees a death benefit that will be at least as much as the premiums you’ve paid. If the investments in your subaccounts have done so poorly that the contract is only worth $10,000 after five years, the rider guarantees a death benefit of at least $50,000. Some Guaranteed Minimum Death Benefit riders may also “step up” this guaranteed death benefit amount or add interest to it from time to time.
Living Benefits
Some Annuity benefits are called living benefits. These benefits all provide some guarantee for the Annuity owner – a guaranteed income from the Annuity, guaranteed withdrawal amounts, and/or guaranteed protection of the premiums you’ve paid. There’s an additional cost for each rider – and the cost can be significant.
Guaranteed Minimum Income Benefit
A Guaranteed Minimum Income Benefit rider guarantees a minimum return on the investments in your subaccounts. Based on this return, you’re guaranteed a minimum income. You usually must buy this rider when you buy your Annuity and must Annuitize to use the rider. For example, this rider might guarantee that your monthly payment will never be less than 75% of your first payment. If the first payment to you was $1,200, this rider guarantees that your monthly payment will never be less than $900, regardless of how the investments in your subaccounts do. You couldn’t use this rider if you took the money from your Annuity in a lump sum payment. And there may be a waiting period before you can use this rider to receive payments.
Guaranteed Minimum Accumulation Benefit
A Guaranteed Minimum Accumulation Benefit rider guarantees that your Annuity will be worth a minimum amount by a set date, even if the investments in your subaccounts do poorly. For example, this rider might guarantee that your Annuity will earn at least 8% a year by the end of ten years. If at the end of ten years your Annuity has only earned 4% a year, your insurer will add the difference.
Guaranteed Minimum Withdrawal Benefit
A Guaranteed Minimum Withdrawal Benefit rider guarantees a return of all of the premiums you’ve paid, regardless of how the investments in your subaccounts do. You must make annual withdrawals, with each limited to a certain percentage of the premiums you’ve paid. This rider does not return the premiums you’ve paid as a lump sum payment. How does it work? For example, suppose you pay $100,000 in premiums for a Variable Annuity and buy a rider that guarantees a 6% withdrawal rate. The rider guarantees you can withdraw $6,000 (or 6% of the $100,000 you’ve paid in premiums) annually without penalty even if the investments in your subaccounts have done so poorly that your Annuity is only worth $70,000. The total amount of withdrawals is limited to the premiums you’ve paid or $100,000 in this example.
Guaranteed Lifetime Withdrawal Benefit
A Guaranteed Lifetime Withdrawal Benefit rider protects you against losses in the investments in your subaccounts. It guarantees that you can withdraw a percentage of your original principal each year without penalty for life, regardless of how the investments in your subaccounts do. For example, suppose you pay $100,000 in premiums for a Variable Annuity and buy a rider that guarantees a 6% withdrawal rate. The rider guarantees you can withdraw $6,000 (or 6% of your original $100,000 investment) annually without penalty even if your Annuity’s account value goes to zero. The percentage you can withdraw is usually based on your age and your Annuity’s benefit base value.
What Are Two-Tiered Annuities?
Most Annuities are single-tiered; the Annuity's account value and cash values become closer together over time. In a two-tiered Annuity, the Annuitization value and the cash value are two separate and independent values. These values are calculated separately and frequently become further apart over time in a two-tiered Annuity.
The cash value of a two-tiered Annuity is the amount that you can withdraw in cash. The cash value balance usually earns a minimal interest rate – one set by the insurer. The Annuitization value can only be used to buy an Immediate Annuity from the insurer at a price the company sets (there's a stated maximum price in the contract). Generally, on a two-tiered Annuity only the Annuitization value will be credited with any bonuses and index gain that you receive. Since most Deferred Annuities are surrendered rather than Annuitized, it's very important to understand that if you buy a two-tiered Annuity, you cannot access the Annuitization value directly as cash. If you withdraw money from the cash value, it will affect your Annuitization value and, during the surrender charge period, surrender charges will apply.
How Do I Know If A Fixed Indexed Annuity Is Right For Me?
The questions listed below may help you decide. You should think about what your goals are for the money you put into the Annuity. You also need to think about how much risk you're willing to take.
These Are The Questions You Should Ask Yourself:
- How comfortable am I with risk?
- After I buy the Annuity, how much money do I need to have available to cover major expenses and emergencies? How much will I have for these expected expenses?
- If I had to surrender the Annuity, am I comfortable with the minimum guaranteed surrender value on the contract?
- Am I comfortable with the length of time that I'll pay surrender charges if I withdraw money from the Annuity?
- How long can I leave my money in the Annuity?
- Does the Annuity let me get money when I need it?
- How soon will I need income payments? How much retirement income will I need in addition to what I'll get elsewhere?
- Will I need income payments only for myself or for myself and someone else?
- If the Annuity loses money, will I still have enough income to meet my needs?
These Are Questions You Should Ask Your Financial Expert Or The Insurance Company:
- When is the earliest I can get money out of the Annuity and how much can I get?
- To which index is the Annuity linked? Do I have a choice? Will I have the option in the future to change the index the Annuity is linked to?
- What is the minimum guaranteed surrender value?
- When is the indexed interest credited?
- Does my Annuity have an interest rate cap? What is it and how long is it guaranteed? Is there a minimum cap? Is the cap in addition to, or instead of, a spread or participation rate?
- Does my contract have a participation rate? What is it and how long is it guaranteed? Is there a minimum participation rate? Is the participation rate in addition to, or instead of, a spread or cap rate?
- Does my contract have a spread? What is it and how long is it guaranteed? Is there a maximum spread? Is the spread in addition to, or instead of, a participation rate or cap rate?
- If there is a bonus, when it is credited and on what amount?
- Is there a recapture provision or vesting schedule which could cause me to lose my bonus?
- Do I lose any bonus if I take a lump sum rather than Annuitize my accumulation value? Are there other ways I could lose the bonus?
- If I take a lump sum and surrender the Annuity, will the accumulated value or the way interest is credited change before I do this?
- Is this a single premium or flexible premium contract?
- Is there a Market Value Adjustment (MVA) feature in my Annuity?
- How long is the free look or right to return period?
- How long is the contract term?
- How much are the withdrawal charges, surrender charges and other penalties? How long do they apply?
- How much can I withdraw without paying surrender charges or losing interest?
- What other charges may be deducted from my premium or contract value?
- How much will the total charges and fees be each year?
- What happens to the money in my Annuity if I die?
Final Points To Consider
Before you decide to buy an Annuity, remember to review the contract terms and conditions, because these vary with each Annuity contract.
It is also important to consider your needs depending on your age, and what you want to accomplish, to make sure that the Annuity is right for your situation. Withdrawing money from your annuity means you may have to pay taxes and/or penalties. If you're replacing an Annuity, you may have to pay direct or indirect costs associated with the new annuity. You may also have to pay surrender charges on the old Annuity if applicable. If you're selling another asset, are there penalties associated with the sale? Will you have to pay taxes on the sale? Annuities are intended to be a long-term product. Generally, you should keep it long enough to avoid paying any penalties.
If you're buying an Annuity to fund an IRA or other tax-deferred retirement program, there may be some additional advantages using this approach. Remember to ask your financial advisor if there any.
Upon delivery of your Annuity contract, READ IT CAREFULLY!! Also, read the insurance company disclosure provided with your annuity. Ask your Financial Company for an explanation of anything you don't understand. You want to do this before any free look period ends.
Any bonuses that are included an annuity, may seem very attractive, however it is important to consider the costs and benefits associated with them. Bonuses can help boost your Annuity's value, but it's important to understand how they work. In general, Annuities with bonuses have higher surrender charges and the surrender charges apply longer than in Annuities without bonuses. In addition, all things being equal, an Annuity with a bonus may have less potential for gains than a non-bonus Annuity. Make sure you understand the terms and conditions of any bonuses you're considering.