Many people who are nearing retirement hope to use the stock market to their advantage. However, uncertain market performance and a lack of clarity about the best financial strategies can scare people off, even those who desire to protect their lifestyle and leave a legacy for their family. This conversation leads many pre-retirees to look into annuities, specifically fixed index annuities.
Fixed annuities are often misunderstood. Many financial services and ads tout them as miracle wealth-generating funds; yet, like all financial products, they are not without challenges. The bottom line is this: as part of a balanced retirement strategy, they can be an effective way to balance growth potential with safe returns, provided people know how they work and who they’re designed for.
This article goes over everything you need to know about fixed index annuities to decide whether to include them in your retirement strategy.
What is a Fixed Index Annuity?
A fixed index annuity is an exchange of a premium paid by the borrower for the insurance company’s agreement to pay back the principal with interest after retirement. Fixed index annuities gain interest based on the performance of a stock market index, like the S&P or Nasdaq, but the idea is that the buyer is shielded from market downturns with this product.
This is the main difference between putting money in a fixed index annuity and putting it directly in the stock market. Rather than buying shares in a stock, the buyer is paying the insurance company for interest credits based on the index. This sounds like complicated financial jargon, but what pre-retirees need to know is this: unlike stocks, fixed index annuities do not lose value even if the index loses value. The insurance company is obligated to pay the interest based on the preset calculations, which safeguards the fund.
How is the Investment Rate Calculated?
Investment rates on fixed annuity indexes are calculated using the participation rate, the cap rate, and the spread. These are technical terms, but they’re important to know in order to understand how fixed index annuities work. Let’s review each one:
- Participation Rate refers to the percentage of the index’s growth added to the fund as interest. For example, if the buyer has a participation rate of 50%, every time the index gains 10%, the buyer’s account earns a 5% investment rate.
- Cap Rate refers to the maximum interest the account can accrue during a specific period.
- Spread (also known as the Margin) refers to a set percentage that is subtracted from the index’s percentage gain before adding interest.
Investors don’t need to know the nitty-gritty of these terms to invest in fixed index annuities. These terms represent the tradeoff that retirees must deal with to get the provider’s protection against market performance changes. Their index annuity will not go down with the market fund, but it will also not grow as fast as the market, resulting in more security but theoretically less growth potential.
Why Pre-Retirees May Consider a Fixed Index Annuity
Pre-retirees within 5-10 years of their retirement should already have a nest egg. Those who do not may need a more aggressive trading strategy to try to beat the market with the time they have left. For everyone else, the biggest threat to their retirement is an unexpected large loss that threatens the security of their savings.
These are the people usually most attracted to a fixed index annuity because its core advantage is security. Those with fixed index annuities will maintain their account value even if the market shifts down since their tax-deferred growth will be tied to stable indexes.
Traditional annuities and CDs are secure as well, but they offer less growth potential. Fixed index annuities can be structured to guarantee income with principal protection and customized features. As part of a diversified retirement portfolio, fixed income annuities can provide low-risk, steady-gain investments for those who place safety over speculation. Yet, they are not without challenges.
Why Pre-Retirees May Be Cautious of Fixed Index Annuities
Protecting the principal against market changes makes fixed index annuities very attractive for many pre-retirees. However, these annuities are not ideal in every situation. These risks should be properly considered before buying into them:
- Time Restrictions: Fixed index annuities limit how much can be withdrawn within certain periods, usually 7-10 years from opening the account, or else the retiree can be charged a penalty.
- Complex Crediting Methods: Figuring out the riders on fixed index annuities can be convoluted without professional help.
- Short-Term Limitations: Those who need to cash out quickly may want to reconsider fixed index annuities, which don’t offer quick access to the fund.
- Earning Cap: The cap rate means that the fund will not capitalize on the full growth of the index, which is the tradeoff for lower risk.
Fixed index annuities can be a great addition to a diversified portfolio, especially for those who already have a nest egg and don’t need to access their funds for a few years. For those who want the full risk and, therefore, the full profit speculation, or those who need to access the funds quickly, fixed index annuities may not be preferable to traditional options.
Partner with an Experienced Insurance Planning Firm to Protect Your Retirement Assets
At Matador Insurance, we know the same plan does not work for everyone. Our experienced team personalizes insurance and annuities for each retiree’s needs. Contact our team today to learn whether a fixed index annuity makes sense for your retirement strategy. Even if it doesn’t, our team can help you make the right plan for your finances and your family.