One way to plan for retirement is by using retirement products that can pay interest such as a fixed indexed annuity. There are many features to fixed indexed annuities, and it's critical to understand how they work to determine if it's the best option for you.
In this article, we'll cover:
What is a fixed indexed annuity? How does a fixed indexed annuity work? How do you buy a fixed indexed annuity? How is interest credited to the fixed indexed annuity? What are the pros & cons of fixed indexed annuities?
What is a fixed indexed annuity?
A fixed indexed annuity is a contract between you and an insurance company that pays interest depending on the performance of a specified index.
A fixed indexed annuity may offer:
- Interest tied to several different indices, such as the S&P 500.
- Interest credited is based on how an index performs, up to a predetermined cap.
- Built-in protection from losses due to negative index performance.
- A fixed account that has guaranteed growth.
- Tax-deferred growth.
- Various income options in retirement.
How does a fixed indexed annuity work?
Because annuities work as both savings vehicles and a source of retirement income, they work in two phases.
1. Accumulation phase of a fixed indexed annuity
This is the period in which you save assets for retirement and build the amount of money in the contract. During this phase, the money in your annuity earns an interest based on the performance of the index it's tied to. Although your premium is tied to the index's performance, funds are not directly invested in it. That means that since your money isn't invested in the index, you don't assume the risk of losing it—your annuity's value may benefit from strong index performance over time, but it won't lose value if the index goes down.
2. Distribution phase of a fixed indexed annuity
The distribution phase is when the money you've saved starts to provide you with income during your retirement. The time between when you start funding it and when you can begin to withdraw without surrender charges will be in your contractual agreement. However, you have the flexibility to decide how you’d like the money from your annuity to be disbursed:
- As a one-time lump sum payment.
Annuitize, which means converting all, or a portion, of your account value to a guaranteed income stream. Depending on the annuity, you also may choose a joint income, which covers you and a spouse for life.
- The product may have a
guaranteed lifetime withdrawal benefit (GLWB)where you may be guaranteed withdrawal amounts for life.
- As monthly withdrawals.
- By withdrawing specific amounts.
Sitting down and working with a financial advisor can help you determine how much to contribute to an annuity and narrow down the best options for distribution.
How do you buy a fixed indexed annuity?
You have the flexibility to decide how you want to fund your annuity. For instance, if you prefer to do it via a one-time lump sum payment, you can
How is interest credited to the fixed indexed annuity?
Once you begin funding your annuity, the interest you earn on your money is tied to an index. For example, if the market is doing well and the index is up, you will get more interest, up to a cap. This creates the potential for more growth from that positive performance—and, at the same time, it limits your exposure if the index does poorly. A rate cap sets a specific limit on interest that can be credited. Alternatively, the interest could be zero if the index performs poorly.
For example, let’s say you contribute $100,000 to your annuity. Assume the annuity is tied to a certain index and has a cap of 4%.
- If the index return is positive and above the cap: You'll get the capped interest rate credited to your account. If the index earns 8%, you will get 4% (the cap).
- If the index return is positive but less than the cap: You'll get an interest rate credited to your account equal to the index return. If the index earns 2.5%, you would get credited 2.5%.
- If the index return is negative or zero: You won't see any loss to your value, but you won't receive any interest either. If the index is down 10%, your return value will remain flat.
Confirm the time period used to measure index returns with your financial advisor. It may run along your contract year or during specific predetermined points in time.
What are the pros & cons of fixed indexed annuities?
Review all your options to understand the pros and cons of various annuities. Doing the research helps you determine the products and strategies that will work best for you.
As with any retirement vehicle, fixed indexed annuities carry both advantages and disadvantages.
Benefits of fixed indexed annuities
- Interest tied to an index. A fixed indexed annuity offers growth potential tied to an index performance.
- Protection. With this type of annuity, you won’t lose value due to market fluctuations. Periods with higher credited interest may offer a way to help hedge against inflation.
- Tax-deferred. You don't pay taxes on your annuity until you
begin withdrawing, leaving more money in your annuity for potential growth over time.
- Guaranteed income in retirement. You may elect to annuitize your contract and create guaranteed income payments for life. Many also offer joint income, which can cover a spouse.
- Beneficiaries can inherit the death benefit. You may list a beneficiary on your annuity, so you can pass on any remaining value to a loved one upon your death.
Disadvantages of fixed indexed annuities
- Capped gains. If the index has positive performance that exceeds the cap, you will only have credited interest equal to the limit.
- Surrender charges. If you withdraw funds within the specified surrender charge period, you may face charges as high as 10% of your annuity’s value.
- Inflation risk. It is possible that your annuity will not keep pace with inflation.
- Interest rate risk. You have the risk that the interest rate that is currently paid on your annuity may be more or less than the rate for other products
The bottom line
For some, adding an annuity may be an excellent tool for your long-term retirement strategy. However, annuities may not be the best fit for everyone. That's why understanding the ins and outs of each type of annuity makes such a difference.
A financial advisor also can help you consider both your current financial situation and your future retirement goals, working to find the best possible fit for your needs.