Fixed indexed annuity pros and cons

As people approach their retirement years and fine-tune their financial plan, fixed indexed annuities can be an important part of their strategy. That's because fixed indexed annuities offer protection of their original investment‍ ‍ ^{See note 1} — and have some upside growth potential.

What is a fixed indexed annuity?

Fixed indexed annuities, also called FIAs, are insurance products that are a little like bonds or certificates of deposit. In other words, they're meant to be a conservative option that preserves your capital or income as you save for a long-term goal.

But in exchange for that downside protection, you also sacrifice some upside potential.

FIAs can be helpful in both phases of your retirement financial plan:

• Retirement savings. When you buy an FIA, your initial contribution grows in value over a designated accumulation period. Your rate of return is tied to a broader stock market index, like the S&P 500®.
• Retirement income. At the end of the accumulation period, the buyer may choose from several payout options, which can include creating a steady income stream — annuitization, a lump sum or rolling the funds into a new contract.

FIA features

• The interest rate credited to you is never less than 0%.
• You decide how much of your account is dedicated to the indexed account and how much is dedicated to the guaranteed1 rate account.
• You may be able to choose an enhanced death benefit rider that provides more payout options‍ ‍ ^{See note 2} to your survivors.
• Some FIAs may offer a guaranteed lifetime withdrawal benefit rider, which can provide guaranteed income for life.

How are FIA rates calculated?

An FIA promises a return linked to the performance of a given index, such as the S&P 500. As the underlying index increases, the value of the FIA may increase.

But FIA credited returns may be lower than the underlying index's returns because:

1. Dividends earned in the underlying index usually aren't included. The participation rate consists of capital growth and doesn't include
dividends.

2. FIA contracts usually include only a percentage of the index's performance. Some common indexing features of FIAs include:

• Participation rate, which is a percentage share of index returns over a designated time span. The participation rate can depend on interest rates, options pricing and management expenses. To illustrate, suppose the participation rate is 75% and the index experiences an 8% return during the measuring period. In this scenario, the return credited to your annuity would amount to 6%.
• Rate cap, which is the maximum rate of positive return that your contract can earn, as set by the issuer. For example, if the index linked to the annuity gained 8% and the cap rate was 5%, then the gain in the annuity would be 5%.
• The "margin," "spread," "asset fee" or "administrative fee" deducts a predetermined percentage from any increase in the index, reducing the potential gain. In the case of an FIA with an index return of 7% and a "spread" of 3%, the return credited to your annuity would be 4%.

It's important to note that fixed indexed annuity contracts often grant the insurance company the ability to periodically modify certain features, such as the rate cap. These changes can impact your overall return. Thoroughly review your contract to understand the potential changes that may be made by the insurance company to your annuity.

Even in cases where the FIA is marketed as a “no fee” annuity, these features can still impact your overall return, similar to how a direct fee would affect it.

Pros of FIAs

Principal protection

The contributions or premiums you pay are guaranteed not to lose value.

Growth potential

FIAs can grow in value over a designated accumulation period. Their rate of return is tied to a broader index, such as the S&P 500, offering the potential to outperform other fixed income alternatives.

Tax deferral

Gains in your FIA contract grow tax-deferred until money is taken out. But if you take a distribution before the age of 59½, you may have to pay penalties or taxes.

Income potential

At the end of the accumulation period, the buyer may choose several payout options, such as annuitization, a lump sum or rolling the funds into a new contract.

Cons of FIAs

Liquidity

Some FIA contracts may require a commitment of at least five years. The contract may place restrictions on withdrawals, so it's important for you to be able to stay the course.

Variable returns

FIA performance is dependent on the underlying market index. The participation rate will vary with market conditions and may be subject to change during the contract period.

Surrender charges

The insurer can impose significant surrender charges if you cancel the contract early. If you take your money out of your indexed annuity before the end of the contract period, you could lose out on the return that would have been applied to your annuity.

Tax penalty

It's important to be aware that under current tax law, withdrawing funds from a tax-deferred indexed annuity before the age of 59½ may get a 10% federal tax penaltyOpens in a New Window.‍ ‍ ^{See note 3}

Insurance company risk

Indexed annuities often promise payments over many years, but it's crucial to remember that these payments are subject to the financial stability of the insurance company. If the insurance company encounters financial difficulties, there is a possibility that they may be unable to meet their obligations.

Other considerations

Before you purchase an FIA, consider the following:

• It can be difficult to compare different FIAs since contract requirements and crediting methods vary among issuers.
• The principal guarantee is dependent on the financial strength of the FIA provider.
• Normally, you're required to put at least $10,000 into an FIA contract, and yearly fees vary from one provider to the next. In addition, you may pay for additional FIA features, such as income riders, enhanced death benefits or higher participation rates.
• If you must get out of the FIA contract before the stated term, you may incur an early surrender charge depending on the terms of the contract.

Your FIA action plan

Step 1: Consider all your resources for secure retirement income and whether they will at least cover your essential retirement expenses.

Step 2: If there's a gap between your guaranteed income and essential expenses and you’re in the accumulation phase of retirement, consider more secure investments in your portfolio, such as an FIA.

Step 3: If you're in the distribution phase of retirement and are seeking secure but limited, growth for portion of your portfolio, an FIA may be worth considering.

Step 4: Review the FIA contract carefully before committing to be sure that it meets your requirements and best fits your financial circumstances.

Step 5: Periodically review the performance and particulars of your FIA contract to determine whether you need to make any adjustments and to make sure that the FIA still fits your needs.