The Basics of Fixed Indexed Annuities
Fixed index annuities might be the favorite all time topic of any advisor with a Saturday morning AM radio show. You know the ones, there's an advisor dispensing financial generalities and often times espousing the virtue of an investment where you make money if the market is up, but you don't lose money if the market is down. That might sound too good to be true. The truth is a little murkier than that. Such vehicles exist, but they also come with a number of restrictions and caveats. As we all learned in grade school, there's no such thing as a free lunch. There's no magic elixir financial product that will allow you to get all of the gains of the market without taking any of the risk that goes along with it. So exactly what are these guys (or girls) talking about, and how does it work? Read on and I'll tell ya!
It's an Annuity
First things first, a Fixed Indexed Annuity is an annuity. And what do we know about annuities? They are a contract with an insurance company, and the terms of the particular contract you are looking at will determine how that particular annuity behaves. There are lots of different types of annuities out there. I've got articles and videos about lots of them but today we're going to focus on fixed indexed annuities. Think about it like an ice cream shop. A milkshake is different than a sundae but you get both at an ice cream shop. An annuity is similar. A variable annuity is different than a fixed indexed annuity, but you get both from an insurance company (the ice cream shop in this example). The key points to a fixed indexed annuity are this:
1.) It has a term. The money has to go there, and live there for a period of time. Common terms on indexed annuities range anywhere from 5-10 years. During this term the money needs to live in the account or you will face penalties for early distribution. Normally there is some liquidity feature that will allow you to access some of the money during the term, but by and large the money must remain in the annuity for that period of time to avoid an early withdrawal penalty. This is also sometimes called a surrender penalty, and the term can be called a surrender term, or a surrender period.
2.) It has a principal guarantee. Nearly all fixed indexed annuities have a principal guarantee. That means that there is a floor under the money and that the balance cannot go down due to market performance (those radio show folks got this part right). The guarantee is provided by the insurance company as part of the contract, and if your annuity has a principal guarantee you won't have to concern yourself with downside market risk. It is important to note that in recent years a similar but not the same annuity has emerged that is often referred to as a "structured annuity" or sometimes as a RILA or Registered Indexed Linked Annuity. The may have a similar interest crediting mechanism to a fixed indexed annuity, but they often still have some downside market risk. If a floor under the value of your money is an important reason for considering one of these annuities, you need to make certain that your contract allows for a full principal guarantee.
3.) There is some interest crediting mechanism. There are multiple ways an indexed annuity can earn interest, and I'll get into them shortly, but just like the other aspects of this sort of vehicle they are contract specific. You need to review the terms of your specific annuity to see exactly how it works. It's also worth noting that the money in an indexed annuity isn't actually invested in the stock market. It is invested with the insurance company, and they have agreed to pay you interest based on the returns of the market (or whatever index they are following) subject to the terms of your particular annuity. As for some examples of those terms..... well keep reading.
Common Interest Crediting Options in a Fixed Indexed Annuity
There are a number of ways an indexed annuity can earn interest, and this list won't be exhaustive, but it will give you a good starting point on some of the common options. Here we go. Normally in an indexed annuity there is some sort of fixed rate. In this case the interest earned will be whatever that rate is, should you choose to allocate to that option. There is no index at play here, you simply earn a little bit of interest, at whatever rate is offered. Typically in an indexed annuity, they can change that rate each year, although in some contracts that rate is fixed for the entire surrender period.
As for the common indexing options, generally you have point to point caps and you have participation rates. Now a cap is exactly what it sounds like. There is a starting point which is the day the money goes in, and an ending point. Typically these are set in 1 year periods, so your end point would be 365 days after that starting point. Some contracts may offer a 2 or 3 year point to point, meaning they measure that interest period for 2 to 3 years. Normally a longer period results in higher caps or rates, but you only have the opportunity to gain once a 2 or 3 years in that case. Now back to have caps work - the insurance company will measure the index from point A (starting point) to point B (ending point) and credit you with interest of whatever the difference is, subject to your cap rate. I'll give you an example: let's say they're tracking the S&P 500. For purposes of our example the contract has a 4.5% cap. Whatever the value of the S&P 500 is on your starting point becomes point A. From there the index goes up, down, or sideways and 365 days later the insurance company looks at it again to determine point B. Let's say in this case the market was up 12% over that year. You're not going to get a 12% return because you had a cap of 4.5%. As a result, you earn 4.5% interest for that year. Now had the market been down over that year, you would not have earned any interest, but you would not have lost any of your investment. It just becomes a 0% year. At that point you start year number 2 with a new starting point and repeat the process again. This goes on each year you have the contract.
The other common indexing option is a participation rate. A participation rate will still have a starting and ending point, just like a cap, but rather than capping your return at a certain percentage they will credit you with a portion of the index return without a cap. Think of it this way. If you had a 50% participation rate, that means you participate in 50% of the upside of the index. If your index is up 20% over that year, you would earn 10% interest (half the upside). If the index was up 3% for the year you would earn 1.5% interest (again half the return of the index). Participation rates tend to offer a higher potential return, but they also tend to underperform in low return years. You would still have the same downside protection in this option as with the cap, so a negative year would result in a 0% return, but no loss of principal.
That's the scoop
Those are the basics of indexed annuities. There is certainly a lot more to it than that, but that should give you a good starting point of how to analyze one of these annuities. The general rule with a fixed indexed annuity is remembering that it's going to limit your upside, but it's also going to eliminate your downside risk. It can be beneficial for the right person in the right circumstance. Oftentimes if you are trying to take a little bit of risk off the table, you may take a portion of your money and move it to a vehicle like this. You certainly don't want to move everything into an indexed annuity because of the restrictions both on how you can access you money, and how your money will grow. But in the right circumstance they can be a valuable planning tool for an individual looking to lower the overall risk of their assets.
Index annuities are insurance contracts that, depending on the contract, may offer a guaranteed annual interest rate and some participation growth, if any, of a stock market index. Such contracts have substantial variation in terms, costs of guarantees and features and may cap participation or returns in significant ways. Any guarantees offered are backed by the financial strength of the insurance company, not an outside entity. Investors are cautioned to carefully review an index annuity for its features, costs, risks and how the variables are calculated.