What is a Ratchet Annuity

Annuities have been a fixture on the investment landscape for centuries.  Once seen as a simple contract between a person looking for a lifetime income stream and an entity that promises one in return for a monetary commitment, annuities have evolved into complex instruments that have become less understood by investors and criticized by financial pundits. 

Fixed index annuities are the latest incarnation and they are no less easy to understand, but they may have silenced some of the critics with its unique ratcheting feature that gives annuity owners the best of both worlds: Participation in upside market performance with no risk of principal.  For anyone with their sights set on the retirement horizon, it would be important to understand how a ratchet annuity works.

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Fixed Index Annuity Basics

Fixed index annuities combine stock market participation with fixed rate and return of principal guarantees.  Unlike a variable annuity where the investor’s cash values are invested directly into the stock market via mutual fund-like accounts, fixed index annuity funds are deposited with the life insurer’s general account where they are invested to achieve returns that mirror those of the major stock indices such as the S&P 500 Index.  Index annuity investors participate in the upside movements of the stock market, yet they are provided protection against downside movements.

Each year on the contract anniversary the index annuity cash value account is credited with a portion of the increase in the index.  This is referred to the participation rate which can be anywhere from 30% to 100%.  An index annuity with a participation rate of 70% would receive that percent of the increase.  30% of the gain is retained by the insurer as an offset to the cost of providing the downside protection.

So, if the index increased gained 10% over the course of the year, the index annuity account values would be credited with 7%.  Conversely, if the stock index declined during the year, the account would not be adversely affected. In fact, many index annuities will apply a minimum fixed rate in down years.  Most index annuities have an upside cap which limits the amount that would be credited in a year when the stock index achieved a big gain. 

What is a Ratchet Annuity?

“Ratchet annuity” is a term applied to a fixed index annuity because, each year, the account values are reset, or ratcheted up to include the year’s gain (based on participation) in the principal. So the principal is adjusted upward to form the new basis in the contract upon which future participation calculations are made.  The account values can never be adjusted downward, so the annuity owner is assured of no loss of principal.

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All Gain, No Pain

Simply put, fixed index annuity owners lock in their gains and they don’t participate in market declines. What this means for long term investing is that fixed index annuities can outperform equity investments that are susceptible to market losses.  Investors in stocks, mutual funds and variable annuities have to endure downside movements in the markets, some of which have been well into the double digits in recent cycles.  In order for investors in these vehicles to regain a positive average annual return, they need to recoup their loss and then some.

In some market cycles it could take multiple years to recoup a year’s loss or a series of annual losses.  In the meantime, fixed index annuity owners maintain their most recent gains and simply wait for the next market increase.  Actual investment performance analysis of the last decade shows index annuities outperforming all other equity investments.

Is There a Downside?

Well, there’s certainly no downside as far as risk to principal.  Also, because index annuities utilize a passive approach to investing, there are no investment management fees such as those charged in variable annuities which are as high as 2%.  The one downside, but one that is associated with all annuities, is that they should be considered as long term investments.  As with most annuities, there may be a fee for early withdrawals if they exceed 10% of the account values. 

One “downside” of a fixed index annuity is that annuity owners won’t participate in big market increases due to the rate cap that is applied on the returns that the insurer credits to the account.  So, if the market gains 25% in a year, the investor will only realize a return no greater than the cap which might be as low as 9%.  Some caps go as high as 25%. 

The other downside is the participation rate discussed earlier which limits the amount of gain credited to the account values. Participation rates can start out high, such as 90%, but they can then drop to as low as 30% if there are no guarantees. Investors can “limit” their downside in ratchet annuities by comparing products for their participation rates (look for guaranteed rates), rate caps (the higher the better), fees (lower the better), and the reset method use (point-to-point or annual reset). 

When the right fixed index “ratchet” annuity is found, it can be the “perfect” retirement vehicle for those with at least 10 years before income is needed. For investors close to retirement, they can still be a perfect investment vehicle if the funds don’t need to be accessed for at least 10 years.  It’s an ideal investment for anyone who likes the idea of “invest it and forget it”.

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