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Should You Get a Fixed Index Annuity?

Nov 28, 2023

Blueprint Income Team

Similar to other types of annuities, a fixed index annuity is a retirement vehicle that can provide you with a steady stream of income after you leave the workforce. However, fixed index annuities also differ from other annuities because they include features that could appeal to people who want comparably high growth potential without exposing them to the risks normally associated with higher returns.

What is a fixed index annuity?

A fixed index annuity is a type of annuity contract whose returns depend on the performance of an underlying index that represents a segment of the financial market, such as the Dow Jones Industrial Average or the S&P 500. You can choose to tie your fixed index annuity to one market index. Some fixed index annuities offer more than one index option. When the linked index performs well, a fixed index annuity can earn you higher returns. At the same time, because you're not investing directly in the stock market, it guarantees principal protection, meaning the interest cannot be less than 0%.

The combination of principal protection and a reliance on market performance to help determine returns distinguishes fixed index annuities from other annuity types. A fixed annuity, for example, offers a set interest rate determined by the insurance company, while a variable annuity does not guarantee a minimum return.

How does a fixed index annuity work?

Like other types of annuities, a fixed index annuity is a contract between you and the insurance company from which you purchase it. After you sign the contract, you pay the insurance company a sum of money in one or more installments, known as the principal. The insurance company then invests your principal into the associated market index or indexes, as well as other investments, which is how the annuity account grows in value.

Interest gets credited to the annuity based on the change in the index at the end of the index term period. The insurance company may consider several crediting factors to calculate the rate you receive on your fixed index annuity, limiting the amount of interest you can earn but offering protection from market losses in exchange. These factors are:

  • Participation rate: The participation rate is the percentage of index gain for your annuity. Imagine, for example, that your fixed index annuity contract has a participation rate of 80%. If the underlying index gains 10%, your account earns an 8% return — 80% of the 10% gain. Keep in mind that the participation rate may be higher in the earlier years of your contract but decline somewhat as you progress through the contract.
  • Spread: A spread, also known as a margin or an asset fee, is a percentage subtracted from an index gain. If the underlying index gains 8% but you have a 3% spread, then 5% interest (8% minus 3%) would get credited to your annuity account.
  • Interest rate cap: An interest rate cap is a threshold placed on your returns. If the underlying index gains 10% but you have a 5% cap, your return would be 5% because you can't earn above the threshold.

Pros of fixed index annuities

Purchasing a fixed index annuity can provide you with the following advantages:

Tax-deferred growth

A fixed index annuity, like other annuity products, grows tax-deferred, meaning you do not pay taxes on your interest earned until later. It is when you start accessing your funds, either through withdrawals or converting the contract into steady income, that you begin to pay ordinary income taxes.

Tax deferral allows you to take greater advantage of compound interest since there is no tax owed on interest earned during the life of the contract. 

Downside protection

Downside refers to the potential decrease in value of an investment vehicle, such as a stock. A fixed index annuity can protect you from downside risk because it does not involve direct investment in the stock market. Therefore, you are not at risk of losing your principal.

Potential for an attractive yield

Though participation rates, spreads, and interest rate caps can limit how much interest you earn, the relationship of a fixed index annuity to the market can lead to potentially higher returns compared to other retirement vehicles. In years that the underlying index performs particularly well, your annuity account stands to earn a percentage of that index's performance.

Diversification

Diversification is a technique for managing the risk of a portfolio, such as a retirement account, by spreading your money across a variety of assets. A fixed index annuity can help you diversify your investment capital because it offers guaranteed principal while benefiting, to a degree, from the positive performance of a market index.

Cons of fixed index annuities

There may also be some disadvantages to purchasing a fixed index annuity, namely:

Less liquidity than other products

A fixed index annuity may be less liquid because it is a long-term retirement vehicle with charges for withdrawals for a set number of years.

During what is known as the surrender period, which typically lasts from three to 10 years, you may be allowed to withdraw up to 10% of your account value, but exceeding that limit results in a surrender charge. The exact amount of the surrender charge can vary depending on when you make the withdrawal. Earlier in the contract term, the surrender charge may be greater, ranging as high as 20% of the account value. As you progress toward the end of the term, the charge amount usually decreases.

No guarantee of index performance

The movements in market indexes are unpredictable, so the interest credited to your fixed index annuity can fluctuate from year to year. Further, the participation rate, spread, and cap limit your upside potential. Also, inflation may cause your principal to lose buying power over time if the index performs poorly and you receive primarily the minimum guaranteed credited interest.

Is a fixed index annuity right for you?

If you are considering a fixed index annuity to supplement your retirement income, you may want to consider consulting with a financial adviser to determine whether it is the right choice for you, as they can outline the potential upsides and risks specific to your circumstances. However, before you make an appointment with an adviser, you can consider these factors to get a preliminary sense of how well a fixed index annuity fits into your existing retirement plan:

Your financial objectives

A fixed index annuity may be right for you if you want both a steady stream of retirement income and the potential to benefit, in part, from the performance of a market index, which could help you realize higher returns compared to some other annuity products. The distributions you receive once you annuitize your contract can supplement other income sources, such as Social Security checks. On the other hand, a fixed index annuity might not work well for your financial objectives if you are behind on your retirement goals as you near retirement, as the returns may not be sufficient for catching up on your savings.

Your time horizon

A fixed index annuity may be appropriate if you are planning for the long term. For example, a 10- to 15-year contract term could give the annuity a better chance to provide overall better returns by allowing it more time to weather market downturns. However, if you think you may need the income more immediately, this retirement product may not be suitable for your needs.

Your risk tolerance

A fixed index annuity may appeal to risk-averse people because it offers downside protection. The credited interest cannot be less than 0%, so you run no risk of losing your principal.

However, fixed index annuities cannot guarantee upside performance, so there is some risk of losing buying power over time because of inflation. Also, because several factors may limit the yield of a fixed index annuity, people who want to take on more risk for higher upside potential may want to consider other options that would allow them to take more advantage of strong market conditions when appropriate.

Use the resources on the Blueprint Income website, such as our instructive start guide and educational articles, to learn more about the different types of annuities and how they can help you realize your financial goals. For more information, feel free to reach out to us at 888-867-7620 or [email protected]. Our team of annuity consultants is available to discuss your needs and provide in-depth knowledge about the annuity options available to you.

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Blueprint Income Team

We are a team of finance, insurance, and actuarial professionals working to make it easier for everyone to achieve a steady and comfortable retirement. We write about annuities (the good and the bad) and provide strategies to help Americans prepare for retirement.