As people near retirement, many search for financial advice on how to prepare financially and leave a legacy for themselves and their families. Fixed index annuities (FIAs) provide one way to grow a nest egg by taking advantage of good market performance while protecting the money against negative market changes.
However, before opening a fixed index annuity, pre-retirees should consider the benefits as well as the challenges of this type of investment. Every situation requires balance, which is why this article goes into greater detail about the pros and cons of fixed index annuities to help you make the right decision for your future finances.
What Are Fixed Index Annuities?
Fixed index annuities are contracts with insurance companies that involve making a single premium or, less commonly, a series of premiums, after which it begins growing in value. After retirement, the value can be withdrawn, annuitized as lifetime income, or left alone to continue growing.
The difference between fixed index annuities and traditional fixed annuities is that FIAs are tied to a market index, which allows them to grow as the market performs well. However, they are also insured against market declines.
This security can be very appealing to those who are nearing retirement or who are unsure about market terms and investment strategies. Therefore, fixed index annuities can be part of a balanced financial retirement plan for some individuals, provided they can recognize the potential benefits and challenges they bring.
What Are The Potential Benefits Of Fixed Index Annuities?
Fixed index annuities carry several benefits over other types of retirement options, including:
Market Performance-Based Growth
FIAs are not directly tied to the stock market’s performance. Instead, the insurance company applies interest to the annuity based on the performance of the index using a predetermined formula. This formula may limit growth based on a rate cap but also provides downside protection against years of little or no growth.
Protection Against Market Downturns
Again, even if the market destabilizes, one of the benefits of fixed index annuities is insurance against poor market performance. In times of no or negative growth, no interest is applied to the FIA, but the annuity will not drop in value.
This acts as extra security for people interested in using FIAs as long-term vehicles for retirement. Since the interest on the annuity will never be less than 0%, buyers don’t have to worry about withdrawing “at the wrong time.”
Different Payout Options
After retirement, buyers can choose from different payout options for their fixed index annuity. These include regular income streams, lump sums, or rolled into a new annuity contract with the insurance companies.
Tax-Deferred Growth
The money in a fixed index annuity is tax-deferred before withdrawal, allowing pre-retirees to pay the premium and only pay taxes on their post-retirement withdrawals.
What Are The Challenges Or Downsides Of Fixed Index Annuities?
Despite these benefits, fixed index annuities also present challenges to for some, including:
Rate Caps
The tradeoff for the insurance company’s protection of FIA interest is the rate cap, participation rate, and spread, which limit how much investment return the account can accumulate. For example, if the rate cap is 5%, the annual gain in the annuity cannot exceed 5%, regardless of market performance. If the participation rate is 80%, 10% market growth would only yield 8% returns. Buyers should be aware of the rates in their FIAs to better predict their growth.
Withdrawal Restrictions
Some fixed index annuities require at least 5 years of commitment before withdrawals are permitted. However, many allow penalty-free withdrawals up to a certain value, often 10% of the account, even during this surrender period. Buyers need to know this withdrawal limit for their individual contract since going above it could cause a penalty on their annuity.
Market Performance-Based Growth
This may be a pro of fixed index annuities, but it can also be a con since dependence on a market index means that returns will not be as predictable as some other retirement account options.
Potential Tax Penalties
The money in an FIA cannot be withdrawn penalty-free until the buyer passes the age of 59 ½. Before that time, the buyer would have to pay a 10% tax penalty on the taxable part of their withdrawal. Although lump sum withdrawals can be available, they often trigger surrender charges or taxes that will cut into the total value.
Insurance Company Risk
Though the insurance company protects the fixed index annuity from negative interest, they cannot protect it in the event that the insurance company itself goes under. Buyers should conduct due diligence, researching providers, and prioritize insurance companies with long-term financial performance to protect their accounts.
Contact Matador Insurance To Learn More About The Benefits Of Fixed Index Annuities
Pre-retirees receive a lot of advice on how to invest in their retirements, and fixed index annuities often come up as low-risk or “no-risk” options. However, no investment is without risk, and the benefits of these annuities, including market-based performance and security against market downturns, also present challenges, including withdrawal restrictions and penalties that buyers should carefully consider.
At Matador Insurance, our goal is to help personalize retirement plans for each situation and weigh the pros and cons of each option, including fixed index annuities. Contact our team today to learn how to open and manage fixed index annuities before retirement, or choose an option that makes more sense in your situation.