Fixed Indexed Annuities: More Potential While Maintaining Protection
An alternative to fixed annuities that provide a degree of market upside with full protection against market loss.
What Fixed Indexed Annuities Are—and What They Are Not
A fixed indexed annuity is a tax-deferred insurance solution, designed for the long term. It combines the opportunity for a degree of participation in market performance with full protection against market loss. A fixed indexed annuity can also be fine-tuned to provide lifetime income, though this article will focus on its use during the accumulation phase of preparing for retirement.
A fixed indexed annuity is not an equity investment in any way and should never be represented as an alternative to owning stocks or mutual funds.
The issuing insurance company commits to paying you, as the policyholder, a return based on the change in price in a particular reference index, such as the S&P 500. However, there are various methods for calculating the interest you earn, and all of them will only give you a portion of any positive change in the index.
Why Would You Consider a Fixed Indexed Annuity Over a Fixed Annuity?
In its simplest form, a fixed indexed annuity offers a return tied to the performance an underlying index, which is typically based on the stock market.
The appeal is that, like a fixed annuity, your principal is fully protected with a fixed indexed annuity, so you have the peace of mind of knowing that your account value will not decline. If the reference index goes down in value over an indexed term, you will simply earn no interest during that period of time.
If you are comfortable with not knowing exactly what your return will be each year, and with the possibility of occasionally getting no return at all in a given year, a fixed indexed annuity gives you more growth potential than a fixed annuity (with less risk and less reward potential than a variable annuity though). It may also offer potentially higher yield compared to bank CDs or government bonds, assuming you are not dependent on a fixed income payment, and comfortable with a long-term investment with uncertainty of returns from term to term.
How Is Upside Potential Achieved?
There are three basic crediting methods that insurance companies use with indexed annuities, all of which are based on the price return of a selected reference index over a specified period of time, or indexed term. Let’s take a closer look at some common crediting strategies with an annual indexed term.
Method #1: Annual Cap Rate Participation
With an Annual Cap Rate Participation crediting strategy, the insurance company looks at the value of the underlying index on each policy anniversary and calculates the return of the index. If the index has a positive return, the account value is credited interest in the same amount, subject to a max return or cap. If the index has a negative return, then no interest is paid for that period. Let’s look at two simple examples.
Example #1: The Market Goes Up
S&P 500 level on policy issue date: 3,000
S&P 500 level on 1st policy anniversary: 3,300
On the policy issue date, the insurance company offers a cap rate of 4%. This is the most interest you can earn during the year, no matter how well the index performs.
In this example, the index goes up 10% (3,300 – 3,000)/3,000). Since the cap rate is 4%, you earn 4% interest on the premium you invested in the fixed indexed annuity. So, if you had invested $100,000 you would be credited interest of $4,000 at the end of the indexed term for an account value of $104,000.
Had the index gone up just 2% to 3,060, then you would earn the full 2% interest on your premium, given the index return was less than the cap.
Example #2: The Market Goes Down
S&P 500 level on policy issue date: 3,000
S&P 500 level on 1st policy anniversary: 2,800
On the policy issue date, the insurance company offers a cap rate of 4%.
With this method, you would not be credited any interest during this first period given the negative return of the index. Certainly no one likes to see no growth in an investment. However, if that happens, it’s likely other investments in your portfolio have declined in value – possibly significantly - and a 0% return in this scenario might be relatively acceptable.
Method #2: Annual Point-to-Point with a Participation Rate
With this method, rather than applying a cap rate, the insurance company gives you a percentage of the positive return in the index. Let’s look at the above example again, but rather than applying a 4% cap rate, we will assume a 30% participation rate.
In the positive return example, the insurance company would once again calculate the return in the index as 10%. Since the participation rate is 30%, you earn 3% interest on the premium you invested in the fixed indexed annuity, or 30% of the 10% index return. So, if you had invested $100,000 you would be credited interest of $3,000 at the end of the indexed term for an account value of $103,000.
If the index return is negative, you will not earn any interest.
Method #3: Annual Point-to-Point with a Performance Trigger
Rather than quote you either a cap or a participation rate, the insurance company gives you a fixed rate they will use to calculate interest to credit to your account so long as the selected reference index is equal to or greater than a specified level, typically its initial level, on the first policy anniversary.
As an example, if the performance trigger rate is 3% and the reference index must stay at 100% of its initial level, then you will earn 3% interest whether the index is up 0%, 5%, 15% or even 40%. As long as the reference index is above its initial level on the 1st policy anniversary, you will earn 3% interest. So again, if you had invested $100,000 you would be credited interest of $3,000 at the end of the indexed term for an account value of $103,000.
Just like the other two methods, you will earn no interest in the years where the index declines in value.
The Power of the Annual Reset
A key feature of a fixed indexed annuity is that the index price resets at the end of each crediting period (usually one year). If the index drops in value during a specific crediting period, it restarts at a new level for the next crediting period. Therefore, you don’t have to wait for it to recover to its original level before you begin earning interest again. A simple example can demonstrate the power of this feature.
Let’s look at a hypothetical return on a fixed indexed annuity with a reference index that starts at 1,000 on the day you fund the annuity and offers 5% annual cap rate participation.
The table below shows how the following reset feature traits can provide more opportunities to earn interest:
- locking in gains as you go,
- no interest deducted due to a negative return in the reference index;
- and the ability to earn interest in any indexed term regardless of index performance in the previous term
Despite the fact that the index at the end of year 3 is below the value on the day the annuity was purchased (990 vs. 1,000), the account owner would have earned interest in two of the three years, illustrating the attributes of reset feature.
Things to Consider Before Buying a Fixed Indexed Annuity
Fixed indexed annuities can be effective long-term planning tools for investors who seek:
- Guaranteed downside protection, no matter how the market fluctuates
- The potential to earn a higher rate of return, although you must be comfortable with a long-term holding period and uncertainty of returns term to term
- An annual reset feature that helps provide more opportunities to earn interest and lock in gains
However, the number of options and variations that are available on most fixed indexed annuities can add to the complexity of the product, and there are several important considerations to understand, including:
- Purchasing a fixed indexed annuity is not an alternative to investing in stocks. In order to provide principal protection, there are clearly defined limitations that can restrict how much you participate in the growth of the underlying index and any dividends of the reference index are not paid to the contract owner.
- Fixed indexed annuities may credit 0% if the reference index return is negative for the indexed term. Historically, the stock market goes down once every four years*. That means if you own a fixed indexed annuity for ten years, you can expect to receive no interest in 2–3 of those years based on past market performance, however past performance is not indicative of future results.
- Early withdrawals or surrender during the surrender charge period may trigger surrender charges, fees, or tax penalties, and may be subject to negative adjustments, which could be substantial. Early withdrawals may also be subject to a market valuation adjustment, or MVA, which can reduce the account value or the actual withdrawal amount. For this reason, an investor should be prepared and able to hold an annuity through the full length of the surrender charge period which is typically between 5-10 years.
- Fixed annuities are not FDIC-insured. All references to guarantees arising under the annuity contract, including optional benefits, are subject to the claims-paying ability of the carrier.
- Withdrawals and distributions of taxable amounts are subject to ordinary income tax and, if made prior to age 59½, may be subject to an additional 10% federal income tax penalty.
In order to find a fixed indexed annuity solution that can work for you, reach out to your financial professional and carefully review the annuity’s offering document, disclosure document, and buyer’s guide for important contract details, including fees and charges.
Want to learn more about managing market risk with confidence? If you’re a financial professional, contact SIMON for a demo and if you’re an investor, ask your financial professional about SIMON.
*Source: Based on the annual performance of the S&P 500 Index from 1957 to 2020.
©2021 SIMON Markets LLC. All Rights Reserved. | 2021.07
This is not intended to be an offer or solicitation to purchase or sell any security or to employ a specific investment strategy. This material is intended as general background information, for educational purposes only, and should not be used as a primary basis to make a decision to purchase an annuity contract. This material is being provided for informational purposes only and does not take into account any specific investment objectives or financial situation of any investor. The information is not intended as investment advice and is not a recommendation about managing or investing retirement savings. Actual fixed indexed annuity contracts may differ materially from the general overview provided. The crediting strategy illustration is hypothetical in nature, does not reflect actual investment results, and does not guarantee future results.
Prior to making any decision with respect to an annuity contract, purchasers must review, as applicable, the offering document, the disclosure document, and the Buyer’s Guide which contain detailed and additional information about the annuity. Any annuity contract is subject in its entirety is to the terms and conditions imposed by the Carrier under the contract. Withdrawals or surrenders may be subject to surrender charges, and/or market value adjustments, which can reduce your contract value or the actual withdrawal amount you receive. Withdrawals and distributions of taxable amounts are subject to ordinary income tax and, if made prior to age 59½, may be subject to an additional 10% federal income tax penalty. Fixed indexed annuities are not FDIC-insured. All references to guarantees arising under an annuity contract are subject to the financial strength and claims-paying ability of Carrier. This does not constitute legal, accounting or tax advice, and the recipient should consult with his or her legal, accounting or tax adviser regarding the instruments described in this material.