For some time, U.S. investors and retirees have been in the strange environment of extremely low interest rates coupled with high equity-market valuations. This has kept returns on annuities lower, but interest rates can change at any time.
Of course, all of this can change at any time. It’s good to consider your interest rate environment, inflation, and other economic issues when considering an annuity.
In volatile markets, retirees and those close to retirement worry about the sequence of returns risk. Sequence risk arises out of the timing of losses. Losses late in one’s investment life, particularly near retirement, are challenging to recoup because of the short time window available. A loss that might be serious at 35 can be catastrophic at 55.
When you are building your nest egg, you have time to recoup from losses. That time may be shorter or longer, depending on your age, but it’s there, and you can recover. On the other hand, when you are actually living off those same assets, a bad return or loss can have a severe impact on your lifestyle. Moreover, since you are likely in a far more conservative asset allocation strategy, your ability to recover from the loss is more limited.
Markets can take huge up or down swings at any time – or simply fluctuate in a small range. Those facing disastrous sequence losses when a market veers rapidly down wonder if there is a way to participate in market gains without facing the full fury of potential market losses.
In these conditions, retirees are looking for a place to obtain some growth but not face the risk of losses in the stock market. They want to be able to participate in some market gains, but not be fully exposed to the risks of actually being in the market. One place to achieve that goal is in the fixed index annuity, or FIA.
What is a Fixed Index Annuity?
A fixed index annuity allows someone to protect their principal while enjoying growth potential tied to a benchmark index’s gains. At its most basic, an FIA is a fixed annuity tied to a specific market index. That index may be a well-known market index, like the ones we hear about daily, or a specially created index linked to a particular market segment.
When someone opts for an FIA, they own an insurance product that can eventually produce a guaranteed income stream. A fixed annuity comes with a specific guaranteed rate of return which may increase slightly, depending on the annuity’s terms, but essentially receives a fixed rate for the length of the annuity.
A variable annuity allows an investor to place all or part of their assets into the equivalent of mutual funds, allowing for asset growth but taking on risk of market losses.
The Balance Between Growth and Protection
A fixed index annuity offers a balance between each of these, and no one has lost money in an FIA due to index losses during a market downturn.
In the typical fixed index annuity, the contract holder may opt for a guaranteed interest rate similar to that of a fixed annuity. However, they may also opt for another option, in which they receive a portion of the gains of the benchmark index to which the annuity is linked. In that case, the growth isn’t guaranteed, but may be higher than what guaranteed rates would be.
As a simple example, if an annuity is tied to the Acme Index, which gains 10 percent in the first year of the annuity, the annuity owner will see growth that reflects a portion of that 10 percent.
On the other hand, if the Acme Index goes down 10 percent, the basic guaranteed rate stays the same. For most fixed index annuities, this guaranteed rate will be zero percent – or a floor of protection for your principal and interest earnings.
How Does Your Money Grow and Stay Protected?
The interest credited is only a portion of the index’s gains because of caps and participation rates. In return for the protection offered from market losses, the annuity purchaser only receives a part of the designated index’s gain.
The participation rate refers to what percentage of the gains that someone will receive. Thus, if Acme goes up 10 percent and you hold an Acme FIA with a 50 percent participation rate, you will receive a rate of 5 percent.
A cap, in contrast, says that no matter how high Acme goes, you won’t receive growth potential that is higher than a set level. Say that the fixed index annuity has a 9 percent cap. In other words, whether Acme goes up 10 percent or 20 percent, your maximum interest earnings will be the 9 percent cap on your money growth.
Much More Than Just Safe Growth Opportunities
There are several important things to remember about any annuity, however. First, they are insurance products, not investments. There is usually a death benefit, and in retirement, you are probably actually looking for that income stream.
The thing to remember about the guaranteed income stream is that the guarantee isn’t a government guarantee like SIPC for stocks or FDIC for banks. It’s a guarantee based on the claims-paying ability of the issuing insurance company. Life insurance companies have a strong record of upholding their promises.
Historically, insurance company failures have been much less frequent than bank failures. Just do your diligence when shopping for your fixed index annuity. With the right due diligence and careful shopping around, you can find the right balance of growth potential and protection for your financial well-being, now and for years to come.
Are you looking for a financial professional to help you in this search, or to help you other crucial retirement ‘what-ifs?’ No sweat, many independent and experienced financial professionals are available at SafeMoney.com to serve you. Get started by using our “Find a Financial Professional” section to connect with someone directly. Should you need a personal referral, please call us at 877.476.9723.