26 Jan Why You Should Consider A Fixed Index Annuity
Fixed annuities are really popular right now. According to the LIMRA Secure Retirement Institute, first quarter 2016 fixed index annuity sales increased by 35% over the same period during the previous year. That marks eight consecutive years of growth, while variable annuity sales dropped 18%, reaching their lowest sales level since 2001.
These divergent results might surprise you, since both types of annuities have ties to the stock market. Variable annuities often invest heavily in stocks, while fixed index annuities frequently depend upon the performance of stock indexes, such as the S&P 500. So why have fixed index annuities taken off while variable annuities continue to lag behind?
Market volatility has challenged the variable annuity business, and some insurers have reduced their variable annuity benefits – making them less attractive. Stock market volatility doesn’t impact fixed index annuities as profoundly, since they have only an indirect connection to equities. They aren’t designed to beat an index, but to compete with bonds, bank CDs, and traditional fixed annuities.
Fixed index annuities offer a value proposition that makes them unique, and well-suited to investors seeking growth potential with downside protection of principal. Many fixed index annuities available today are more investor-friendly than their predecessors, with lower fees and more generous benefits. They can allow conservative investors to earn higher yields than bank CDs or high-grade bonds.
What is an index annuity?
Index annuities are contracts issued and guaranteed by an insurance company. They promise both preservation of principal during down markets and investment growth that’s linked to an index such as the S&P 500. The return credited to your account depends partly on how much the index changes. Insurance companies use various methods to track changes in the index value, and it’s important that you understand how the index is tracked – since that will have a direct impact on your return. Investing in a fixed index annuity is very different than putting money in a CD or a bond paying a fixed rate of interest. Fixed income annuities are complex instruments, with most having a traditional contract value and a secondary income base value. There are typically several indexes to choose from, including the ‘point to point’ S&P 500.
Limiting Downside Risk
Many fixed index annuities guarantee a minimum return, regardless of the performance of the underlying index. This permits the portfolio to grow without market risk, ensuring the security of the invested premium. A fixed index annuity makes sense for those individuals who are retired or nearing retirement, and need guaranteed income for life. It can serve as a personal pension, producing a monthly income the investor never outlives, and replacing lost employment income during retirement.
The guaranteed income component of a fixed index annuity frequently comes from an income rider purchased along with the contract. This rider will likely be a guaranteed lifetime withdrawal benefit based on a phantom account growing at a specified rate – irrespective of any market index performance. Fixed index annuity purchasers may buy the annuity, watch as the income value increases over the years, and eventually take penalty-free withdrawals for life, based upon the higher of the income value or the annuity’s accumulation value. With or without an income rider, fixed index annuities may be attractive to investors due to the lack of downside risks typically associated with equity investing.
While fixed index annuities do provide downside protection against adverse market movements, they aren’t perfect. For starters, you’ll sacrifice participation in stock dividends. Since indexes exclude dividends, your return from an index annuity won’t include them either. Secondly, market gains could be limited by an upside participation cap. The participation rate is the percentage of the index’s return the insurance company credits to the annuity. For instance, if the market rises by 8% and the annuity’s participation rate is 80%, the annuity will have a 6.4% return. Finally, fixed index annuities sometimes carry steep fees, including a contingent deferred sales charge. Investors often fail to comprehend just how long these back-end fees can go on.
New fiduciary rules from the Department of Labor may negatively impact fixed index annuities on a temporary basis. It’s still too early to know how the industry will react to these new rules, or how sales might be affected by them. In volatile markets, however, downside protection has a lot of appeal. With so many baby boomers transitioning from asset accumulation to asset distribution, some retirees and pre-retirees may wish to devote a larger portion of their portfolio to the creation of a lifetime income stream. There will still be strong demand for guaranteed income, which will likely continue to drive the popularity of fixed index annuities for years to come.