Welcome to Texas 1st Financial
What’s an Indexed Annuity?
A fixed indexed annuity is a type of annuity that’s a contract between an individual and an insurance company. Under this contract, the individual makes a lump-sum payment via check or IRA transfer to fund the account. The insurance company, in return, invests the money in a safe portfolio mostly composed of high-grade bonds and government treasuries. The difference with indexed annuities is that the principle is protected and growth potential is tied to the performance of a market index, such as the S&P 500.
Indexd Annuities strike a unique balance between growth potential and no risk. They offer the opportunity for potentially higher gains compared to fixed annuities due to their link with market indices. At the same time, they protect the individual against the risk of market downturns because the contract owner will never lose money.
Because of the downside protection, the performance of fixed indexed annuities is limited due to features such as cap rates, participation rates and margins.
These factors determine how much of the index’s gain will be credited to the annuity on an annual basis.
The evolution of indexed annuities has seen the development of more complex indexing strategies with the aim of maximizing returns while maintaining a safety net against market losses.
Today, indexed annuities fit as a part of a balanced financial plan. They occupy the middle ground between aggressive growth investments and conservative fixed-income options. Those who enjoy the protection component but want growth closer to market yields find the perfect balance with fixed indexed annuities.
- The contract can be credited with a fixed interest rate
- The fixed interest will be used to buy an option in a market index
- If the index is positive, earnings from the option are credited to the annuity as earnings
- If the index is negative, interest earnings are lost
- The principal is never at risk so the contract will not lose money
- Several index options are available within each contract and a blended allocation of indices can be used to diversify opportunities for accumulation
How Fixed Indexed Annuities Work
- You invest money into an indexed annuity with an insurance company.
- The insurance company invests your money into a pool of safe assets. Interest earnings from those investments are used to purchase an option on a market index
- After one year, if the index is positive, the insurance company credits your account with a portion of the index’s gains, up to a certain limit.
- Several different index options are available in every contract, are chosen upon at issue, and can be changed at each contract anniversary.
- Each contract allows a portion of the money to be withdrawn every year without penalty. Distributions from the contract in excess of this amount will face a surrender penalty.
Surrender Penalties
Market Value Adjustments
Guaranteed Minimum Surrender Value
Contract Maturity
Additional Riders and Benefits
Various optional riders can be added to fixed indexed annuities that provide one or more additional retirement benefits. Each contract may have a single additional option or a combination of the below. All are mostly responsible for any fee you might see on a fixed indexed annuity.
Guaranteed Lifetime Income
Long Term Care Enhancements
Guaranteed Death Benefit
Return of Premium
Enhanced Performance
How do insurance companies cover the risk involved?
Insurance companies carry no risks directly associated with the issuance of fixed indexed annuities. Premium from these contracts is invested and held in the insurance company’s general account so the safety of fixed indexed annuities is on par with the insurance company as a whole.
Typically, 90% or more of an insurance company’s assets are well diversified and stable holdings of high-grade bonds and US Treasuries. Every annuity is backed by these assets, dollar for dollar. In addition, each company holds significant reserves that insulate the company from the ups and downs of a normal business cycle.
Fixed indexed annuities are backed the same as any other general insurance obligation. Each insurance company has partnerships with investment banks to manage the options used in each annuity. Since the insurance company only uses interest earned on assets to purchase these options, the principal investment is never at risk and is just as safe as any other insured asset.
How a Fixed Indexed Annuity Grows
When you invest in a fixed indexed annuity, the insurance company uses your premium to buy a portfolio of bonds and other safe instruments. This returns a yield to the company. With a fixed annuity, you would be credited with the interest earned.
However, with a fixed indexed annuity, the company instead uses the earned interest to purchase an option in a market index. If the market index increases during the term, then the option makes money and this gain is credited to your account. If the index declines, the interest invested in the option is lost, but your principal balance is never at risk.
The worst-case scenario is that you’ll earn 0% for a term, but you have the opportunity to see yields in the double digits. The real benefit is that once interest is credited to your account, it can never be lost.
Interest Crediting
Addition of interest or gains to your account balance. This happens at the end of each crediting term which is mostly on each contract anniversary. Several different crediting terms are available with the most popular being each year, with other optional terms in a range of two to ten years, depending on each contract.
Yields
“Yield” refers to the earnings or return on an investment. It’s the income returned on an investment, which includes interest or dividends received from holding a particular security.
Protecting assets comes at the cost of some growth. Reasonable people understand this but still want to get the best deal.
Many contracts are sold with the idea that you can earn as much as, or more than, long-term stock market averages. While this would be nice – and is possible – it is not something you should expect. If an agent is giving you overblown promises, then you need to look at the other questions more closely.
In the context of index annuities, if the market index increases during the term, then the option makes money and this gain is credited to your account as yield. If the index declines, the interest invested in the option is lost, but your principal balance is never at risk.
The worst-case scenario is that you’ll earn 0% for a term, but you have the opportunity to see yields in the double digits. The real benefit is that once interest is credited to your account, it can never be lost.
Yields will vary depending on type of contract and you should consider four important things:
- Current Fixed Interest Rate: Each fixed indexed annuity is first a fixed annuity with a fixed rate of interest available. Any percentage of the total funds can be allocated to a guaranteed fixed rate option, one year at a time.
- Cap Rate: States the maximum amount of interest that will be credited to the account if index performance is positive.
- Participation rate: States the percentage of positive index performance that will be credited to the account. There is no limit to interest earnings with a participation rate.
- Margins: A rate of interest deducted from positive index performance before a credit is made to the account. There is no limit to interest earnings with a margin.
Your Fixed Indexed Annuity Overview
How does an Annuity Company Make Money?
When you invest in an annuity, the insurance company uses your premium to buy a portfolio of bonds and other safe instruments. This returns a yield to the company. With a fixed annuity, you would be credited with the interest earned. However, with a fixed index annuity, the company instead purchases an option in a market index. If the market index increases during the term, then the option makes money, which is how the company generates a return on your investment.
The document also mentions that some annuities may have hidden fees. When fees are added, they can either decrease performance or lock you into a contract longer than you want. These fees are another way that annuity companies can make money.
It’s important to note that different contracts may have different terms and conditions, and this can significantly impact the potential returns from an index annuity. Therefore, it’s crucial to fully understand the contract and how it fits into your overall financial strategy before investing.
Pros and Cons of Fixed Indexed Annuities
Each of the individual components of a fixed indexed annuity can be seen as a pro or a con, depending on your expectations and goals. Let’s look at each of the major components and the positive attributes of each.
Pros of Fixed Indexed Annuities
- You will never lose money.
- Credited interest is guaranteed against loss.
- Yields that are far greater than any safe asset.
- Protection from interest rate risk.
- Many indices to choose from.
Safety
Earnings Guaranteed
Caps, Participation Rates and Spreads
Surrender Periods
Indices and Crediting Methods
Conclusions
- Fixed index annuities are a type of investment product offered by insurance companies.
- They provide the potential for higher yields compared to other safe money options.
- Fixed index annuities protect the principal balance from loss.
- The suitability of an annuity depends on individual circumstances and goals.
- Key benefits of index annuities include safety, growth potential, liquidity, and the option of guaranteed income riders.
- Beware of overblown promises of earnings and hidden fees.
- The safety of index annuities in a market crash and how annuity companies make money.
- The choice of a fixed index annuity company should be based on the specific features and benefits of the annuity that align with your goals and retirement plan, rather than the reputation or promises of the company itself.
- Before you buy anything, you must understand the contract and how it fits into your overall financial strategy before investing.