Fixed Index Annuity Investment

What is a fixed index annuity?

In order to really make sense of a fixed index annuity, we need to take it apart and then put it back together.  The basic concept is not difficult, but a fixed index annuity has quite a few “moving parts”—terms and conditions that vary according to which major insurance company sells the annuity.

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Annuity: Technically, an insurance product rather than a direct investment in a stock or mutual fund, an annuity protects your principal, yields a reasonable, guaranteed rate of return, and then pays-out your earnings in equal installments over an extended period of time.

Index: Although “index” has other obscure uses in the world of finance, here “index” refers to one of the major stock indices to which your annuity is tied.  Most often, the major providers link their fixed index annuities to the Standard & Poor’s 500, generally considered the most reliable among the diverse market barometers.

Fixed: (as opposed to “variable”) the annuity contract stipulates all the terms and conditions of investment and pay-out.  The investment and pay-out periods are established in advance, as is the guaranteed rate of return and other terms that vary from provider to provider.

Fixed Index Annuity: An annuity tied to a stock market index and guaranteed a minimum rate of return with opportunities for earnings above the guaranteed minimum as the stock market rises.

Because they technically are insurance products rather than stocks or bonds, fixed and indexed  annuities guarantee the safety of your principal and your minimum rate of return.  A variable annuity does not protect your principal if the company’s investments perform poorly.  A fixed index annuity guarantees the value of your investment never will be less than the sum total of your payments; and it offers the opportunity to exceed the fixed rate of return if growth in the Standard & Poor’s Index exceeds your minimum.  More of a wealth management tool than a wealth-builder, a fixed index annuity does not have dazzling growth potential, but it does have the distinct advantages of stability and security.

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How does a fixed index annuity work?

Here’s where the “moving parts” kick-in.  The basic mechanism remains the same no matter which fixed index annuity you choose, but the details vary—sometimes radically:

Basic: You invest for the long haul, and you lay the foundation for secure retirement..  The longer you can continue investing, the longer you benefit from the stock market’s recovery.  As the stock market index rises, your earnings percentage rises with it.  If the S&P falls, your earnings never fall below the guaranteed minimum.  When you reach the expiration of your investment phase, the annuity begins paying you in regular installments. 

“Participation Rates” vary: No annuity will give you a return exactly equivalent to the growth of the S&P 500.  Participation rate describes how much of the index’s total gain the annuity company will pay out to you.  90% is properly generous, but some companies offer as little as 50%.  Therefore, if the S&P Index rises 10% over the period your annuity uses to measure growth, and you participate at 90%, you earn 9% on your investment.

Formulae for growth vary: The math remains fairly simple, but the choices may mystify: Your provider may calculate a point-to-point change or an average change, and the “points” vary—monthly, quarterly, six months, or a year.  In other words, if the annuity provider says “we pay the average rate of growth every six months,” they take each month’s growth over the six-month period and calculate the average.  In a volatile market, this formula may work to your advantage; but in a steadily growing market, you forfeit a little.  The alternative: The company says “we calculate annual growth.”  In most cases, that means on the anniversary of your purchase, your provider calculates the percentage by which the S&P has risen, divides by the participation rate, and pays the result.  If the S&P rose 15% and you participate at 90%, your annuity earns 13.5%.

Pay-out periods vary: Investors favor either a pay-out period identical to the investment period, or lifetime pay-out with a survivors’ benefit.  Because investors put their money in annuities for the sake of securing steady retirement income, the lifetime pay-out assures they will not out-live their incomes.

Cautious investors buy fixed index annuities to assure steady retirement income.  For a hard-working professional at the upper end of the American income scale, a fixed interest annuity offers an excellent complement to direct investments in stocks and a 401(k) or Roth IRA.  Over the long term—twenty or thirty years--an annuity probably cannot out-perform riskier investments; but it provides safe and secure retirement savings at a guaranteed rate of return.  Most financial advisors probably would not recommend substituting a fixed index annuity for another retirement plan; but, in keeping with investment professionals’ advice always to diversify, a fixed index annuity represents a perfect hedge against losses in other, riskier vehicles. 

Among different annuities, a fixed index annuity represents the “moderate risk” investment—slightly more risky than a fixed annuity which pays one guaranteed interest rate for life, and slightly less risky than a variable  annuity tied to mutual funds.  Naturally, the annuity that allows mutual fund investments has more earnings potential, but the rate of return could go to zero in a serious bear market. 

In a bear market, a thirty-year old investor monitors the S&P, and as soon as it establishes a “bottom,” he or she purchases a fixed index annuity to capitalize on the stock market’s recovery.

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