Fixed index annuities combine the safety of a fixed annuity with partial participation stock market index. A fixed indexed annuity offers the contact holder the potential for participation in market upside, with the safety of a guaranteed interest rate and no risk of loss of principal. The fixed indexed annuity is a perfect antidote to the unknowns of variable annuities.
Fixed indexed annuities are also known as equity indexed annuities. This is simply because the rate of interest at which the annuity appreciates is tied to an index of equities. ‘Equities’ is a term that securities regulators take issue with, however, because the word “equity” often implies a stock or investment.
The scrum of regulators trying to get their hands – and their regulatory fees – around these products has led to confusion in the marketplace. The reality is, these are insurance products that have both a fixed interest rate, and a variable upside potential linked to but not directly invested in, a stock market index.
Understanding Fixed Index Annuities
Now that the name is out-of-the-way, what is a fixed indexed annuity? This can be best understood by first talking about the fixed annuity.
When you invest in a fixed annuity, your premium is invested by the insurance company in their portfolio of bonds, real estate mortgages, and other secure assets. The entire pool of assets is available to pay all claims and redemptions, and income payments. The fixed rate that is declared by the insurance company each year is much like a dividend on those pooled assets.
With a fixed indexed annuity, the underlying premium purchases a similar set of secure instruments, like bonds or mortgages. But rather than using the income from these investments to credit directly to your account, the income is invested in options which participate in an underlying stock market index, such as the S&P 500 or the Dow Jones.
So, the insurance company has a known income from their investments, and they take that income and buy participation in the market index. If the market index goes up, the options make money, and a portion of the gain in the underlying index is credited to your account. If the index does not go up, the options can expire worthless. If the options expire worthless, you might not make any income for that time period, but you fall back on the safety of the underlying investment and your principal is secure.
Benefits of Fixed Index Annuities
Now that we understand the features of the fixed index annuity – how they work – we need to look at the benefits.
Principal Guarantee:First of all, it should be obvious that an investment that guarantees no risk of loss to principal, and potential appreciation based on a market, is a good thing. Many people look at the word ‘guarantee’ and get suspicious. But if you examine the structure of the contact, and understand how the option strategy is used to buy market participation, you can see how your principal investment is truly never at risk. Incidentally, this is a very similar strategy that hedge funds use in sophisticated trades, and used for the same reasons- risk mitigation. Thus, no risk of principal loss is a primary benefit.
Low Fees: Fixed indexed annuities also have much lower cost structures and a higher degree of certainty for insurance companies, so they are much lower cost to operate. Consequently they have lower fees when compared to Variable Annuities. That said, when riders and additional optional benefits are added, these annuities can get expensive on an annual basis, so be careful to select just what you really need.
Market Participation: Uninformed commentators will often say that the insurance company does not credit enough of the market appreciation, or is ‘stealing’ market gains and dividends, but this is actually misguided. As your underlying premium is not directly invested in the market, there is no way it could participate in dividends. And further, the income generated by your premium invested in secure assets would not be sufficient to buy options to participate for the full amount of your premium in the market. Therefore, most fixed indexed annuities have a partial participation in the market, such as 30% to 50% of the index gain.
Fixed Index Annuity Riders
Fixed indexed annuities are often bundled with extensive riders and add-on benefits. Just as with variable annuities, the addition of a guaranteed lifetime income benefit rider turns a fixed indexed annuity into a “hybrid annuity” simply because it is a hybrid of appreciation and income attributes.
Explore more about Hybrid Annuities here.
Fixed indexed annuities offer potential appreciation with the protection against loss.
Fixed indexed annuities together with income benefit riders also offer a one-stop shop to invest accumulated assets in a tax-deferred appreciating vehicle and then later turned increased principal into an income stream.
Combining many benefits into one product, however, can make for a very long planning horizon. Allow the experts at Annuity Ace to to find the best available fixed indexed annuity to suit your needs.