For many consumers the decision to invest can be a difficult one. With so many options available, so many banks and corporations offering investment terms, the process can be such a headache many will simply not invest. This however would be a...
Fixed Indexed Annuities
Fixed Indexed Annuity: What is it?
A fixed indexed annuity, also referred to as an equity annuity, is an investment which is insured and ties your interest rate to growth of a major stock market index. As the stock market index rises, your account is credited with interest by insurance companies who take a cut for themselves. However, when the stock market index falls, your principle is protected by the insurance companies against losses with a low interest rate or return. What makes a fixed indexed annuity so popular is that it combines the best features of fixed annuities and variable annuities.
History of Fixed Indexed Annuities
It was about thirteen years ago that the first fixed indexed annuity was purchased. In its short lifetime, the fixed indexed annuity has profited from economic booms and stood up against economic catastrophes—exactly what it was made to do. September 1998 to September 2003 was one of the worst five years stretches since the Depression, yet fixed indexed annuities returned an average of 33.7% to investors, which is much higher than its competition. Overall, the fixed indexed annuity has proven to be a firm competitor in the marketplace.
Comparison of a Fixed Indexed Annuity and a Fixed Annuity
The main feature that a fixed indexed annuity has over a fixed annuity is that a fixed indexed annuity takes the risk out of investing in the stock market. The reason for this is that, with a fixed indexed annuity, you are guaranteed by the insurance companies a minimum rate during poor market conditions. While a fixed annuity offers the same guarantee of a constant return rate, the fixed indexed annuity gives investors the opportunity to cash-in equity-based growth. While the investor may not know how much money their account will accumulate over the years, debt based instruments are always out-performed by equities.
Comparison of a Fixed Indexed Annuity and a Variable Annuity
What makes a fixed indexed annuity superior to a variable annuity is that a fixed indexed annuity is recession proof and can protect your investment from other economic mishaps. Seeing as an important aspect of gaining wealth is the ability to manage losses effectively, a fixed indexed annuity allows you to maintain a constant return rate despite the gloomy economic state. So while variable annuities and loosing their investors money, the safety net provided by a fixed indexed annuity gives you comfort in knowing that you are still earning money.
Why People Choose a Fixed Indexed Annuity
What makes a fixed indexed annuity so attractive to investors is the simple fact that a fixed indexed annuity is guaranteed to make the investor break even, thereby giving the investor piece-of-mind. Unlike the variable annuity, which depends upon the state of the economy, fixed index annuities cannot be negatively affected by economic downturns as they are guaranteed a constant rate of return. Also, that people can cash in equity-based growth makes fixed indexed annuities more attractive that fixed annuities. Overall, with the benefits offered by fixed indexed annuities over fixed and variable annuities, fixed indexed annuities should give investors piece of mind when investing and/or planning for retirement
Pros and Cons of the Fixed Indexed Annuity
Pros and Cons of Fixed Index Annuities
A fixed index annuity combines the best features of a fixed annuity and a variable annuity. It provides the potential for gain in the equity markets, while at the same time, limiting the possibility of loss during market downturns.
The return for a fixed index annuity is tied to the fluctuations in a major market index, such as the Standard & Poor's 500.
Pros of Fixed Index Annuities
- Offers a minimum guaranteed interest rate, which limits downside loss possibility.
- Potential for higher returns during a rising market as compared to a fixed annuity. Since a fixed annuity has a guaranteed, the return can never be higher, even in a rising equity market.
- Less market risk than variable annuities. While there are advantages to equity indexed variable annuities, there is also the possibility of the loss of principal in a market downturn.
- More suitable to risk-averse investors. There is comfort in knowing that you are going to receive a guaranteed amount of income no matter what the market does.
- Can invest in either single premium fixed index annuities or make flexible premium payments. Most companies offer the plan to make installment premium payments based on the investor's available cash flow.
- Returns accumulate tax-free. Taxes are not paid until withdrawal when the annuitant's tax rate will probably have a lower tax rate.
- Income payment options are very flexible. The investor can decide how and when he wants to receive payments.
- Virtually no risk of loss of principle. The primary risk is the potential insolvency of the issuing insurance company. However, recognized rating firms, such as Moody's and AM Best, rate the insurance companies so you can be sure you are dealing with financially solid firms.
Cons of Fixed Index Annuities
- The return is only a percentage of the gain in the market index.
- The annuity may have a maximum cap on the return.
- Surrender charges can be high for withdrawals, although most companies will allow a withdrawal up to 10% without a charge.
- Annuity offerings can be difficult to understand. The issuing companies use various methods of computing participation returns, setting the caps and determining the fees.
The features of fixed indexed annuities vary widely from company to company. The investor must determine his needs and carefully read the terms and conditions of the various annuity offerings.
Glossary of Annuity Terms
Fixed Indexed Annuity
A fixed indexed annuity as an annuity that can be either a deferred or immediate annuity that provides benefits or earns interest that is linked to an equity index or external equity reference. The value of the index may be tied to a stock or other equity index. They way interest is credited to an annuity's value is what makes an indexed annuity different from other types of fixed annuities. Interest credited using indexed annuities involve the use of a formula that is based on changes in the index that is linked to the annuity. How the additional interest of the annuity is credited and calculated will be determined by the formula used.
Indexing Method
The most common indexing methods that are used to determine the interest amount of the fixed indexed annuity are point to point, high water mark, and annual reset, also known as ratcheting.
Point to Point
An indexing method used to determine interest credited to an account using the difference from the beginning of a term until the end of a term. Normally, a point to point index is based on an annual basis, but it is also common to use a three year point to point index or a point to point for an entire term of an annuity. In many cases there is a specific cap on the percentage that can be earned.
Annual Reset/Ratcheting
Compares the index value at the end of a contract year of a fixed indexed annuity with the starting of the term. The index is then reset at the end of each contract term. Interest is calculated for year two based on the beginning and end of the index.
High Water Mark
An indexed annuity that is tied to the S&P 500 in which the value of the annuity is calculated by averaging the value of the monthly S&P values over 12 months. In the event the market value increases during any of the years in which the annuity is active, the value over the full term of the annuity will only increase in years that the value goes up, but will not decrease in years when the average value is down.
Term
The period in which a surrender charge is calculated is known as the index term. Generally, these terms are between five and fifteen years. Once the end of the term comes to pass, it is typical that the money can be withdrawn without any penalty, although there is normally a free withdrawal term available during the term of the annuity as well.
Vesting
Determines how much of something that is yours to keep, which is typically the amount of interest you can earn as a bonus over the term of an annuity.
Participation Rate
This is the deciding factor in the amount of the index performance to be credited to an account as interest. It is normally determined for a specific period, which can be from one year to the entire term of the annuity. When the period expires, a company will typically set a new participation rate. Some companies may guarantee a minimum participation rate even in the event the rate is reset annually.
Administrative Fee/Spread/Margin
Normally expressed in terms of a percentage, the administrative fee, spread, or margin is a fee that is subtracted from the percentage of the change in the index.
Cap Rate or Cap
This is the term used for when an annuity company sets a limit on how much of the performance of an index can be credited to an account as interest. A cap rate can be set to change over the entire term of an annuity or on an annual basis.
Compounding Interest
Simply put, compounding interest is getting interest on top of interest. Interest earned is calculated not only on the value at the time, but also on the interest that has been earned over that time.
Minimum Guarantee/Floor
This guarantees an annuity holder a certain percentage of interest even in the event the performance of the index being used is negative or zero.
Averaging
Rather than using the change from the beginning to the end of an annuity, the value is determined by the average of a particular index.