Fixed index annuities are more complicated than they look — and that’s saying something.
These complex instruments blend elements of both fixed and index annuities into a tool that is its own animal. And while the pitch to consumers is that a fixed index annuity combines the potential upside of market gains with a safety net that protects account holders from market downturns, annuities specialists say that the actual return is dictated in the fine print. This hybrid tool may or may not deliver on its promise to consumers who want assured returns, even if they are willing to take a discount for that security.
What is a fixed index annuity?
A fixed index annuity is a money management tool sold by insurance companies that credits rates based on a market index and guarantees that the principal will not be reduced, even if the market turns down.
“It has the same fundamental structure as a fixed annuity if you want both safety and a tolerance for variability,” says Tamiko Toland, a consultant to financial services firms. “You can’t lose money. It’s generally going to be going up over the long haul — five to seven years — so you can expect a couple percentage points more.”
How a fixed index annuity works
The primary virtue of fixed index annuities is that investors cannot lose their principal — at least, not directly, she says.
But there are many moving parts in the calculations that determine an account holder’s eventual return, and that makes it anything but straightforward to figure out how much money you might gain. “The problem is the confusion around indices and the equity component. It has evolved to be extremely complicated,” she says, “with all the types of indices that do different things.”
If the initial formulas for return were permanently set, fixed index annuities would be slightly less tangled. But the calculation may change every year over the term of the annuity, which makes it all but impossible to forecast even a ballpark return.
The key elements are the index that drives the overall return and how much of that return is credited to the annuity.
Well-known indices, like the S&P 500, have records that potential account holders can review — bearing in mind, of course, that past performance is not a conclusive predictor of future performance. But some fixed index annuity contracts use obscure or even custom indices, which makes it difficult to understand how they might perform.
Then, a potential investor must assess how the return is credited to the account. This process results in what is often called the “participation rate.” The participation rate is the proportion of the index-driven return that the account holder gets to keep. If the participation rate is 50%, the account holder gains half of the returns dictated by the linked index. So, if the participation rate is 50% and the annuity gains 8%, as dictated by the associated index, the account holder gains half of that — a 4% return.
The pros and cons of fixed index annuities
In 2023, interest in annuities of all kinds spiked because interest rates rose in 2022, which meant that insurance companies could offer greater benefits on their contracts. All annuities, including fixed index annuities, look like a way to lock in higher returns for a few years.
But interest rates go up and down, cautions William C. Reynolds, a certified financial planner with G5 Financial Group, and, despite first impressions, so can the net rate of return on a fixed index annuity. Terms buried in the fine print allow insurance companies to change key factors that ratchet down the return due to the account holder.
“People buy these products thinking they’re participating in the stock market for no risk but that’s not it, especially when considering the participation rate,” he says. Some companies also charge what is known as a “spread fee,” which is a charge levied after the participation rate is calculated.
If interest rates rise and bond prices fall (interest rates and prices are inversely correlated), insurance companies may lower participation rates to offset losses on their investments. If interest rates go down, they may increase the participation rate or just keep it the same and enhance their profits.
As noted, the participation rate is the proportion of market gains that the account holder actually keeps. So, if the market returned 10% for one year of the annuity, and the participation rate for that year was 45%, the account holder’s return would be 4.5%, explains Reynolds.
Typically, companies use fixed index annuity funds to buy long-term bonds or other bond holdings, which are used to calculate a guaranteed return for the annuity. A portion of any gain indicated by the index that frames the annuity is then returned to annuity holders.
But companies also give themselves leeway to change the rate of return to account holders according to the performance of those bonds. Thus, the underlying performance of bonds and interest rates affects the calculations that companies use to adjust annuity returns.
Separately, the spread fee also impacts the account holder’s return. Continuing with the example of a 10% market return trimmed to a 4.5% return due to a 45% participation rate, the account holder’s ultimate return would further be reduced by the spread fee rate, which is typically 2%, resulting in a 2.5% net return.
In Reynolds’ experience, participation rates and spread fees are so onerous as to make fixed index annuities inappropriate for all but the most conservative investors who crave a little bit of market lift without any market risk.
“Younger investors, in my opinion, should never do a fixed index annuity because you’re tying your hands behind your back,” says Reynolds. “If you’re younger, you have time to ride the ups and downs of the market.”
Tax implications of fixed index annuities
As with all annuities, income taxes are not due until the account holder takes the accumulated returns as income.
Some potential investors are dazzled by the prospect of postponing the income taxes eventually and inevitably due, says Reynolds, but it’s important to understand the assumptions that insurance companies use to illustrate the value of this tax ploy.
Be sure that any example reflects your actual circumstance, especially your tax bracket and how often you turn over long-term accounts, thus triggering taxes, he explains. The value of endlessly rolling over the fixed index annuity might not be as generous as you hope. Even if you use this type of annuity to leave money to heirs, they, of course, will have to pay taxes when they claim the accumulated gains held in the annuity.
Be sure to compare the tax implications of a fixed index annuity to that of leaving money in a regular (not tax-sheltered) investment account, for which heirs would take a full step-up in cost basis (an upward adjustment of asset values to their fair market value at the time they are inherited) that would ultimately minimize the taxes they paid.
How to buy a fixed index annuity
Financial advisors and insurance agents sell fixed index annuities. It’s possible to buy this type of annuity directly from an insurance company, too. Be sure to review the value of this type of instrument in the context of your overall portfolio. As well, be sure to review the entire contract so you are familiar with the crediting strategy (often called the participation rate), the associated index and other factors that will dictate your net return.
Frequently asked questions (FAQs)
The entire point of all annuities is that account holders are shielded from market downturns, say annuity specialists. But, as with all annuities, account holders are only allowed to withdraw small amounts of money before the term is up. While market downturns cannot erode principal, it is possible to lose money by taking all or much of the funds early, triggering fees and penalties.
Often, says Toland, longer-term annuities are more generous with withdrawal policies, allowing account holders to tap some of the gains before the entire annuity matures.
Key elements of the formula that dictate the return from a fixed index annuity will change — market performance will definitely fluctuate, and the crediting formula (participation rate) may also change. That makes it impossible to see if fixed index annuities are worth it, say Reynolds and Toland. With that said, some online calculators may help account holders at least see how returns might add up under various “What if?” scenarios. Such experiments are not conclusive but can give you a feel for the factors that will shape the return of a fixed index annuity.
Annuity specialists say that annuities allow account holders to take out a small amount of money per contract year — at the very least, the 10% withdrawal rate required by government rules — without paying a penalty or fee.
But because all annuities, fixed index annuities included, are designed to keep account holders’ money locked up for a specific period of time, most of the money is not available without invoking penalties or fees. A good alternative to a fixed index annuity, advises Reynolds, is a medium-term bond fund, which is a conservative investment that allows the account holder to withdraw money at any time, with no fees or penalties.
Always review all the terms of an annuity contract with your financial advisor to see how much flexibility a particular contract allows.
Annuities experts agree that this complicated form of investing is not for beginners and requires the guidance of an annuity expert. Look for an insurance agent or financial advisor who has earned the “certified annuity specialist” certification, which indicates that that professional has gained particular expertise in the arcane world of annuities.
Insurance companies are regulated by state departments, which require regular assurance of financial performance and sufficient assets and reserves to cover their obligations to customers. While it is rare, it is possible for an insurance company to go out of business. In that case, the state insurance agency covers customers’ accounts. If you are concerned about the financial solvency of an insurance company, contact the insurance regulator for the states in which that company is licensed to do business.
Typically, when you buy an annuity, you can choose how often you receive payments. Remember that you are taxed on annuity income when you receive it, so the timing of annuity payments will intersect with other tax considerations, especially if you have income from tax-advantaged accounts, such as a 401(k) or individual retirement account (IRA).
Credit: Source link
