Some index-based financial products have a “floor,” or the maximum value you would lose if the index went down. In a fixed indexed annuity, the floor is expressed as a guaranteed minimum interest rate. This floor is usually set at at an annual rate of 0%, meaning that even if the index decreases in value, the interest to be credited won’t be negative.
Essentially, the annuity floor will consist of your annuity’s accumulation value plus the guaranteed minimum rate. You can never lose money due to any index declines. But your money may lose value in the times of index losses, if the indexed annuity contract has optional rider fees or you pay a surrender charge for early withdrawals.
If you are researching fixed index annuities to see if annuities may be for you, it’s helpful to have a good knowledge of the essentials. Let’s get started with a more in-depth discussion of a fixed indexed annuity, some of its common features, and how the floor guarantee may work.
A Quick Intro to the Fixed Index Annuity
With a fixed indexed annuity, you do not invest directly in the stock market. Fixed index annuities are insurance contract products, not investment accounts. A fixed index annuity may also have different growth potential than other annuities do.
Because it isn’t directly in the stock market, a fixed index annuity differs from a variable annuity, which may be exposed to market investment risk. That is one reason why variable annuities are classified as securities and overseen by the Securities and Exchange Commission.
When you purchase an indexed annuity, you give a lump sum to an insurance company and enter into a contract that links your crediting interest to the particular index. Many fixed index annuities let you choose indices like the S&P 500®, the NYSE®, or the NASDAQ®.
Now, here’s where the floor comes into play:
- If the index linked to your contract falls, there is zero interest earned.
- However, your principal—and any already-credited interest— won’t be affected.
- In exchange for this floor protection, the growth potential for a fixed index annuity is limited by caps, participation rates, and spreads.
- If the chosen index rises, some of that growth, but not all, is credited as interest to your contract.
Because of this contract design, insurance carriers can assure that when the index declines, you won’t lose any money due to market risk. This protection applies even when there are significant index losses.
Keep in mind that the insurance carrier may change, at different times, the specific rates of the caps, participation rates, or spreads. Check the specific details of any annuity you may be considering for more information.
This characteristic of principal protection is why FIAs are often chosen by investors with a more risk-averse tolerance. They may want to take a conservative approach with the portion of their portfolio they would like to protect, while still gaining the advantage of potentially outpacing certificates of deposit or Treasuries.
The insurance company guarantees that your original annuity principal won’t fall in value, as long you as don’t make early withdrawals. As with all annuities, that guarantee is based on the financial strength and claims-paying ability of the insurance company.
What’s My Floor?
To recap, the “floor” is the minimum index-linked interest rate you would earn. In most fixed indexed annuity contracts, the floor is 0%. According to FINRA, state insurance laws also require fixed index annuities to pay a guaranteed minimum rate of 1-3% on 87.5% of the paid premium dollars.
While most indexed contracts use floors to preserve your principal, the majority of indexed annuities will preserve any credited interest as well as your principal. This can mean that your principal and credited growth are “locked in” even when the index goes down.
How Do Other Financial Products Compare?
Other financial products may come with a floor. However, in most cases, they aren’t like the floor of an indexed annuity contract. They may protect just a certain proportion of your principal, as some bonds do. Many financial products have no floor or minimum guarantee for protection at all.
As in the case of a cap, not all annuities have a stated floor on index-linked interest rates. But in all cases, your fixed annuity will have a minimum guaranteed value.
Keep in mind that while your principal and credited interest may be protected by the floor, you may lose money to optional rider fees. Surrender charges or withdrawal charges, along with income tax obligations, can also affect the value of your money.
These annuity guarantees of a floor will hold as long as you stay in the fixed indexed annuity contract. And the ability of an insurance carrier to uphold this promise is only as good as its financial strength and claims-paying ability. Be sure to investigate the background of any insurance companies which may be under consideration for any annuity contract purchase.
Are Fixed Index Annuities Right for You?
You will want to work with a qualified financial professional who can analyze your needs and assess if this or other options are right for your goals. In general, fixed indexed annuities may appeal to investors who:
- Have “conservative money” to invest.
- Do not want to expose a portion of their money to market risk.
- Want access to their money, but understand they could face surrender charges if they withdraw too much and/or too soon.
- Are interested in benefiting from a share of the growth when their index rises in exchange for protection against negative interest if an index falls.
- Have interest in using fixed-type annuities and principal protection as a “foundational” part of their retirement portfolio strategy.
No single annuity design may have all the features you want. You will need to decide what combination of features makes the most sense for you.
If you need more information about annuities in general, take a look at the Annuity Insights Guidebook. This 50+ page reference guide on annuities can help you simplify your research process, make the most of your time, and help you cut the learning curve short.
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