“Index investing” is a passive investment strategy used by some investors in an attempt to generate returns comparable to a broad market index.
Proponents of index investing believe that it’s impossible to beat the market once you take fees and taxes into account. Many people involved in index investing find index funds to be more tax-efficient than active funds. Index investing enthusiasts point to lower management fees and expense ratios as positive aspects of the approach.
Indexing tries to match the risk and return of the overall stock market on the theory that the market as a whole will outperform an individual stock picker.
Fixed indexed annuities were designed to offer retirees and pre-retirees an opportunity to benefit from market gains, building upon the index investing strategy.
Unlike fixed annuities, which pay set rates, indexed annuities offer their owners a way to earn higher yields while providing some protection against downturns.
How do indexed annuities work?
Rates on indexed annuities are determined by the “year-over-year” (YOY) gain in the index or the average monthly increase in 12 months.
While linked to a specific index, such as the S&P 500, indexed annuities will not necessarily pass along the full benefits of any upticks in that index. For one thing, many indexed annuities set limits on potential gains. This limit is known as the “participation rate.” A participation rate can be as high as 100% or as low as 25%, though it is typically in the 80-90% range. If an annuity index, for example, performs at 20%, and the participation rate is 50%, earnings will be 10%.
Another potential limit on yields in a fixed indexed annuity is a “rate cap.” Annuity contracts with rate caps will further limit the amount credited to your annuity’s accumulation account, by anywhere from 7- 15%, depending on the contract. You need to ask about both the participation and cap rates before purchasing a fixed indexed annuity.
The UPSIDE of a market downturn
While caps and participation rates can impact your gains during a market upswing, a fixed indexed annuity provides a measure of protection during downturns by crediting your account with a minimum rate that is usually around 2%. The issuing company will, at specified intervals, adjust the value of your annuity to include gains that happened during that time frame.
Another plus for owners of fixed indexed annuities is that your principal is guaranteed to NOT decline in value except in certain instances when you take withdrawals.
As you can see, fixed indexed annuities are a more nuanced and complicated product than you might have realized.
Before purchasing this kind of financial product, you must understand what money problems you need to solve. If you are looking for dependable, tax-deferred growth, need guaranteed lifetime income, principal protection, or want to leave a legacy for your loved ones, fixed index annuities might be the right solution.
Having a secure income source that you can’t outlive is a great reason to consider fixed index annuities. But, you must do your research and due diligence before purchasing.
You will also want to find a trusted annuity expert in your area who can explain the moving parts of a fixed index annuity to you and your spouse. This expert can also answer your questions about how annuities are taxed and provide you with information on how they can help you solve long-term care needs or longevity risks.
If you are retired or within 5-7 years of retirement, it would be wise to investigate whether or not a fixed indexed annuity can help you achieve your overall retirement goals.
