Managing Risk with Fixed Index Annuities

By on January 1, 2017

Over the past decade, the financial market has experienced extreme swings and with such volatility, Americans are rethinking traditional retirement income and investment sources. Despite conditions today being relatively stable, many investors are still wary of the potential for severe losses. Additionally, many financial experts see this return to a high volatility market as being the new normal, with the expectation of another large market correction looming on the horizon, an inevitability driven by competing economic factors.

In response to this need for a way to protect savings from volatility over the long-term, financial advisors and their clients are turning to carriers for a financial product which provides a guaranteed level of income. Enter the fixed indexed annuity – an insurance product which allows clients to participate in gains generated within the market, while limiting exposure to losses.

Whether your goal is to build a guaranteed stream of income, save for specific retirement goal or leave a legacy for your loved ones, today’s fixed index annuities offer a range of features and benefits. Let’s explore the basics in more detail.

Fixed Index Annuities: How They Work

An annuity is a contract between you (owner or annuitant) and an insurance company which provides you income – either immediately or at some time in the future – in exchange for your premium payment(s). An indexed annuity is a special class of annuities that yields tax-deferred returns based on the performance of a specific stock market index, such as the S&P 500.

Unlike direct investment in an index using a brokerage account, the fixed indexed annuity product itself offers a contractual guarantee against investment losses. The insurer credits interest using a formula based on changes in the index to which the annuity is linked. The formula decides how the additional interest, if any, is calculated and credited. How much additional interest the contract earns and when it is credited depends on the features of your particular annuity.

The Benefits: Tax Deferral, Growth and Protection

A fixed index annuity offers a unique combinations of benefits and protections. During the accumulation phase, interest is earned based on the growth of the index. If the index’s performance is positive, your contract will be credited interest and it cannot be lost in the event the index declines in the future. This means your assets may grow at a fast rate.

Potential growth means you need a suitable level of protection. Fixed index annuities may protect you in three (3) ways:

  1. Accumulation: The principal and earned interest are protected from market downturns
  2. Guaranteed Income: You are protected from outliving your assets
  3. Death Benefit: Your beneficiaries may receive income if you pass away before the distribution period

Under current federal tax laws, any interest earned in the fixed index annuity contract is tax-deferred, meaning you do not have to pay income tax until the contract distributes the money (there may be penalties for withdrawals prior to age 59 1/2). This tax-deferred growth may increase the amount of income your annuity generates for your retirement or long-term savings goal.

Index Methods

There are many ways insurance companies calculate the interest earned by your index. It is important to understand the type of crediting method used by the insurer, to help you choose the right type of contract to suit your requirements. Keep in mind that caps, participation rates and spreads (margins) may also be included in the crediting method.

For a better understanding of how each method works, speak with your trusted team of financial advisors. Here are the most common crediting methods:

  • The point-to-point method measures the values of the index at two distinct points, such as the end and beginning of the contract term or each month. While this may protect you against any volatility in the index thru the middle of the term, it could miss out on some increased values.
  • The high water & low water mark methods measures interest earned by comparing the index level at various points during the term (usually the policy anniversary dates) and then compares the highest or lowest level to the contract start date. Both methods tends to lessen the risk of market declines.
  • The automatic annual reset locks in any interest your account earned during the year by resetting your annuity’s index values at the end of each contract year. The current year’s ending value becomes the next year’s starting value.

Manage Extreme Volatility with an Un Capped Spread Method

Traditionally, a fixed index annuity sets a top limit (cap) on the credited interest generated by the index. For example, if the index’s value increases 15 % and your annuity has a cap rate of 8 %, your annuity will only be credited up to the cap rate. An uncapped index annuity removes that ceiling on earnings so you can reap market gains along with the index.

An uncapped fixed annuity allows you to take advantage of extra interest crediting potential when the index does well, but still earns a minimum interest rate without any loss of principle when the index takes a downturn. Carriers may use a variety of ways to ensure uncapped does not mean unlimited, however, the benefits of surviving bear markets can far outweigh the limit on returns.

One method may be to calculate the change in the index value at the end of the month or year, then the spread (margin) is subtracted.  A spread is essentially a fixed percentage that is subtracted from any gain that the indexes generate within a set period. For example if the the gain in the S&P 500 for a policy year was 15% and the company used a spread of 3%, then, 12% would be credited to your policy for that year. A spread is only charged when the index “wins” – if the market loses or experiences a downturn, no spread is applied. This method is excellent for weathering dramatic volatility and sharp declines.

Is a Fixed Index Annuity Right For You?

The answer is, maybe. In the search for reliable solutions to protect assets and create growth opportunities, uncapped fixed index annuities have great potential – protection and higher interest rates than your average low-interest bearing savings account.

For investors who are risk-averse or those who have maxed out contributions to their tax-advantaged retirement savings vehicles, this may be the financial product you need to balance your portfolio and reach your long-term retirement goals while facing little volatility. Thanks to a guaranteed minimum return you will not have to worry about losing your principal investment, however, you and your team of trusted financial advisors will want to find an annuity and crediting method which offers the best risk-reward correlation to suit your personal situation.

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About Harold Goldman

I am the founder of FinancialSafetyNet.org, and a Retirement Planning and Long-Term Care specialist. I am also the President of Emes Insurance Services, Inc., a Murrieta based insurance agency designed to help people with Retirement Planning and funding for College. I believe in educating my clients to become financially competent in an effort to develop plans for guaranteed income, protection against loss and tax-advantaged growth. To contact me Call (844)-376-2265

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