Is a Fixed-Indexed Annuity a Good Investment? What You Should Know

If you have some tolerance for market volatility, but still want a relatively safe way to invest for the medium to long term, a fixed-indexed annuity could be a good fit for your portfolio. If you prefer a very safe annuity option, a fixed annuity may be more appropriate.

There’s no one-size-fits-all formula for retirement planning. You have to figure out what works best for you. Fixed-indexed annuity products were designed for people that want a relatively safe place to put their retirement savings, but who still wanted some market exposure — and the risk and potential reward that comes with it.

If that sounds like you, fixed-indexed annuities could be a good choice. In this article, we explain what fixed-indexed annuities are and under what circumstances you might choose them.

The Basics of Fixed-Indexed Annuities

A fixed-indexed annuity, also known as an equity-indexed annuity, is a type of annuity contract that you buy from a life insurance company. Like all annuities, it offers tax benefits and can provide a guaranteed income in retirement.

Fixed-indexed annuities are one type of deferred annuity. When you buy one, you fund it with payments called premiums. The time during which your annuity is earning interest is called the accumulation period. Once you decide to annuitize your contract, you enter the payout period.

Fixed-indexed annuities are different from other types of annuities in how they calculate the interest crediting rate. The annuity you chose will have index options to chose from. The performance of your chosen index, such as the S&P 500 or the Russel 2000, will determine your crediting rate.

If those indices perform well, you earn a higher crediting rate on your money. If they perform poorly, you earn a lower crediting rate or you may not earn anything. Usually, these types of annuities also offer a “loss floor” — a guaranteed minimum interest rate between 0% and 2% that your rate will not fall below.

This combination offers upside potential while also offering a protection against losses. This provides the potential to earn higher rates, while also protecting your principal so you don’t lose your money if your chosen stock market index performs poorly.

Key Considerations Before Buying a Fixed-Indexed Annuity

Here are a few factors to help you decide whether a fixed-indexed annuity is right for you.

Potential Gains May Be Limited

Insurance companies typically impose an upper limit, or "cap," on the amount of interest you can earn in a given period. That means even if the market is booming and your chosen stock market index is soaring, you’ll be limited on how high your interest rate will go.

These limits may take a variety of forms. One is a set participation rate. For example, imagine the participation rate is set to 50%. If the market index you chose—say, the S&P 500—gains 10% in value, your interest rate would be 5%.

It’s also common to set a maximum rate of interest. For example, if your insurance company set a cap of 7%, and the index increased by 10% or 20%, your rate would be 7%.

Losses are Limited Too

The reason insurance companies set an upper limit on fixed-indexed annuity rates is to balance their potential losses. Most fixed-indexed annuities have a loss floor — usually between 0% and 2%. That means that even if the linked index has no gain or a loss, the rate that will be applied to the annuity will not be less than the minimum guaranteed rate.

So, no matter how the market index performs you will not lose money in your annuity because of a negative interest rate.

Exact Returns are Uncertain

One benefit of fixed-indexed annuities is that they can potentially generate interest rates higher than regular fixed annuities — as long as the market performs well. But, because you cannot know what the market will do, it’s difficult to predict what your returns will be.

Depending on the market, sometimes your crediting rate may be quite high; and other times, it may be very low. This makes fixed-indexed annuities a less stable or predictable option for growing your retirement savings compared to other options like fixed annuities.

Tax-Deferred Growth

Fixed-indexed annuities also offer tax benefits for growing your retirement savings. They provide tax-deferred growth, which means that you delay taxes on your gains until you take the money out, similar to an individual retirement account (IRA) or 401(k).

This has two benefits. First, your money will grow faster since you don’t have to pay taxes right away. Second, you pay taxes only when you receive distributions. Since most people take their withdrawals in retirement when their income is quite low, they end up in a lower tax bracket and pay fewer taxes overall.

Remember that annuities aren’t tax free. When you start withdrawing money from your fixed-indexed annuity, you’ll pay ordinary income taxes on the earnings portion of the withdrawal. The tax treatment of withdrawals is determined by the tax status of the premium payment you used to purchase the annuity — whether it is qualified or non-qualified. It will also depend on the method you choose to receive the withdrawals.

Note that annuities offer tax deferral because they are meant for retirement. If you take withdrawals before the age of 59½, you may have to pay a tax penalty to the IRS.

Read more: All about annuity taxation

Fees and Surrender Charges

Like most financial products, fixed-indexed annuities come with costs. Here is a list of some charges you may have to pay for a fixed-indexed annuity.

• Management Fees. Annuity companies charge fees to cover the costs of managing the annuity. Rather than charging an up-front fee, they usually charge this fee as a percentage of the assets in the account. This fee is typically only seen on variable annuities, but could be charged on a fixed-indexed annuity as well.
• Return limits. Some annuity companies set return limits. That means that in years when the market generates a high return, they may keep a portion of your earnings. If you have to pay this fee, it will be specified in your contract.
• Surrender charges. Surrender charges are fees that you have to pay if you make early withdrawals during the surrender period or if you cancel the contract. They are typically a percentage of the account value and can be as much as 10%. However, they usually get smaller the longer you have the contract. Note that some annuity contracts allow for limited withdrawals without fees even during the surrender charge period. This amount would be indicated in your contract as a free withdrawal percentage or penalty free withdrawal percentage.
• Riders. When you buy an annuity you can choose to purchase additional add-on features, called riders. Optional riders provide extra benefits, such as guaranteeing a minimum return on the policy. You may be charged a one-time fee for a rider, or you may have to pay an annual charge.

Fees differ significantly from contract to contract. If you have questions about yours, consult your contract or talk to a representative from your annuity company.

Guaranteed Lifetime Income

The problem facing most retirees is this: What if my money runs out?

All annuities can offer guaranteed lifetime income if you choose that option when you annuitize but there are also optional riders that can help you generate more lifetime income than your base annuity would.

An income rider, also called a “guaranteed income benefit rider” or “lifetime income rider” can help you generate additional income in retirement. Income riders are commonly offered for the more risky variable annuities and fixed-indexed annuities. They usually cost extra, but they can add security because you can generate additional income for the rest of your life.

Who Are Fixed-Index Annuities Right For?

Fixed-index annuities give you some market exposure while still staying relatively safe. They offer the potential to earn higher returns if the market performs well while limiting your losses if it doesn’t.

These features make them ideal for long-term investors who are comfortable with some risk, but who want to ensure that they don’t lose money from a negative rate of return.

While fixed-indexed annuities limit losses, the minimum interest rate that they offer is usually still very low — often 0%. That means if the stock market index you choose performs poorly, you might not generate any returns. So, these annuities aren’t ideal for the most conservative investors. Also, these are long-term products meant to be part of a retirement portfolio. They’re not appropriate for shorter-term investors.

Are There Any Alternatives?

Yes, there are many alternatives. If you want shorter-term investment options, mutual funds or stocks may be a better choice. If you want very safe, shorter-term savings options, certificates of deposit (CDs) may be more appropriate.

If you want an annuity for your retirement plan, but don’t want the risk of earning nothing on your savings that fixed-indexed annuities can have, a fixed annuity might be preferable.

Fixed annuities don’t offer any market exposure and their rates don’t change based on market performance. Instead, you get a fixed minimum interest rate. They’re better for you if you’re more conservative and want your nest egg to grow at a steady rate.

All annuities are long-term products that can offer a steady stream of retirement income. The right annuity for you depends entirely on your retirement goals and financial circumstances. If you think an annuity could be a good fit for you, feel free to contact Canvas’ licensed reps. They are knowledgeable and can explain the differences between different annuity products and plans.

If you’re interested in high guaranteed rates on fixed annuities, click here and, apply today.