One of the most critical things in retirement is not having enough income to last one's lifetime. Retirees often look for strategies to include in their retirement portfolio that provide them with a reliable source of income and protect them from an unpredictable stock market that can prematurely deplete their retirement savings. One strategy they may consider is an annuity. Here are a few things to know about annuities:
- An annuity is a contract between you and the insurance company in which the insurance company agrees to pay you periodic payments for a set term.
- Annuity payments can start immediately or in the future.
- Annuities are purchased with either a single payment or a series of payments called premiums.
- Some annuity contracts provide a way to save for retirement, others turn your retirement savings into an income stream, and others do both.
- Annuities offer tax efficiency while they accumulate value; they lock in gains based on market performance.
- When the market declines, the fixed portion of the annuity protects the accumulation and initial investment.
- Earnings grow tax-deferred
- Provide a guaranteed death benefit of the initial investment and can include survivor benefits through a policy rider for an additional cost.
There are three types of annuities: fixed, fixed-indexed, and variable annuities.
In this article, we examine fixed-indexed annuities to help you determine if purchasing one is appropriate for your situation.
What is a fixed-indexed annuity?
A fixed-indexed annuity is a complex financial instrument with a guaranteed minimum fixed interest rate and an interest rate linked to a market index, such as the S&P 500 or other indexes. Fixed-indexed annuities have more risk and more potential return than fixed annuities. But, fixed-indexed annuities have less risk and potential return than a variable annuity.
How is interest credited to a fixed-indexed annuity?
Fixed-indexed annuities credit interest in two ways:
- From the fixed sub account a minimum interest rate is calculated.
- From the indexed sub account, the change in the index between two points determines the interest rate.
Indexed annuities pay a guaranteed minimum interest rate contingent on holding the indexed annuity until the end of the term. Indexed-annuity guarantees are also contingent on the insurance company's claims-paying ability that issues the annuity's contract.
The indexed portion of the annuity measures the change in the index to determine the interest rate. However, fixed-indexed annuities do not directly invest in the index or the equities comprising the index. The index is merely the instrument used to measure the gain or loss in the market. Examining the value of the index at specific points in the annuity's term, such as the annual anniversary, provides points to compute the difference between the date-of-issue value or the date-of-maturity value to determine the interest rate.
Understanding How Interest Rate Caps Work
Some indexed-annuities have an interest rate caps limiting the growth on the upper limit interest rate the annuity will earn. The cap is set to help ensure that the annuity provider, the insurance company, can meet their obligations and still make a profit on the product. The cap helps protect their portfolios if the index sees a significant upswing. Here's an example of how an interest rate cap works:
The indexed-annuity interest rate cap is 7%. If the index earns 11% during the term, the annuity will only be credited the 7%.
The Pros and Cons of Fixed-Indexed Annuities
Like any investment vehicle, fixed-indexed annuities are not without risk. Before purchasing a fixed-indexed annuity, it is essential that you understand each feature and how they work together, and any fees or expenses that come with a particular product. Here are some of the pros and cons of fixed-indexed annuities to consider:
- A fixed-indexed annuity has the feature of guarding against the loss of principal
- No contribution limit
- A guaranteed minimum return from the fixed sub account
- Tax deferred growth
- Taxes are due on distributions when withdrawing in the form of payments.
- Riders for an additional cost to add features such as lifetime income, second to die with income for life
- Fixed-indexed annuities can be expensive.
- It be complex to understand
- You may have surrender charges if you surrender the policy early
- You may incur a tax penalty that could reduce or eliminate any return if surrendered before age 59 1/2.
Purchasing an annuity is one way to provide a predictable income stream during retirement. Be prepared to ask your financial professional specific questions to help you determine if a fixed-indexed annuity is appropriate for your situation. Contact us to learn more.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing.
Fixed Indexed Annuities (FIA) are not suitable for all investors. FIAs permit investors to participate in only a stated percentage of an increase in an index (participation rate) and may impose a maximum annual account value percentage increase. FIAs typically do not allow for participation in dividends accumulated on the securities represented by the index. Annuities are long-term, tax-deferred investment vehicles designed for retirement purposes. Withdrawals prior to 59 ½ may result in an IRS penalty, and surrender charges may apply. Guarantees are based on the claims-paying ability of the issuing insurance company.
All indexes are unmanaged and cannot be invested into directly.
Fixed and Variable annuities are suitable for long-term investing, such as retirement investing. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Guarantees are based on the claims paying ability of the issuing company. Withdrawals made prior to age 59 ½ are subject to a 10% IRS penalty tax and surrender charges may apply. Variable annuities are subject to market risk and may lose value.
S&P 500 Index: The Standard & Poor's (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization US stocks.
All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy.
This article was prepared by Fresh Finance.
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