How Do Fixed Index Annuities Work?

Fixed Index Annuities are much like a normal fixed annuity, but they have a different method of crediting interest.

With a fixed annuity, the contract owner receives a stated rate of interest each year.

But with a fixed index annuity, the appreciation rate is calculated based on growth in an outside market index.

If the index goes up, the contract makes money. But if the index goes down, the principal is protected and the contract does not lose value.

Index annuities give consumers partial participation in the gains of the equity markets in exchange for principal guarantees.

Index annuity owners will not lose money no matter how badly the market performs. It is a place for safe money.

How Insurance Companies Make This Possible

When you purchase a fixed annuity, you give the insurance company your premium and they essentially invest it in bonds and conservative vehicles like mortgages on commercial real estate. This is known as the insurance company’s ‘General Account’.

Whatever return the general account generates, less company operating expenses, equals the interest credit rate available for the annuity contract.

As an example, let’s assume the insurance company general account portfolio yield is 6% and that annual operating expenses are 2%. In this case, a fixed annuity will be credited with 4% interest.

Your fixed annuity contract would guarantee you a 4% guaranteed rate of return for a period of time (typically 3 to 10 years) and that’s exactly what you would receive.

Enter The Fixed Index Annuity

In a fixed index annuity, your premium is invested in the same general account as the example above, but you have two basic options with the interest income. You can elect to take the base interest rate (which is roughly equivalent to the ‘general account’ and what a fixed annuity would pay) or you can opt for the possibility of more growth.

If you opt for more growth, the company uses the interest earned from the conservative portfolio to purchase an option position in a market index. An option is simply the right- but not the obligation- to purchase securities at a future date for a contractually stated price.

If the market goes up, the company will exercise the option and realize a gain. They credit a portion of the gain on that option contract to your annuity contract.

If the market moves sideways or down, the option expires worthless and no interest – or gain- is available for crediting.

The cost of the option position typically uses up your interest earnings for the year from the conservative underlying investments. So while the principal is safe and securely invested still, its earnings were used up by the option and thus, you have a flat year with no interest credited.

Potential for Gain with No Risk of Loss

Index annuities truly offer you the potential for gains based on market appreciation, without the risk of loss to your principal.

Your principal is not at risk, rather, it’s only the earnings from your principal are invested in potentially higher yield options. Thus, an indexed annuity is a safe asset with upside potential.

This explanation also gives you a good idea why these are called “Fixed Index Annuities”. Income from the FIXED account growth is used to buy options in a market INDEX for potential gain.

If the market rises, you may profit. If the market falls, the company has wagered only your income from the FIXED account, so your principal at all times remains safe.

Pros and Cons Of Fixed Index Annuities:

Pros

Principle and Growth Guarantee- Your initial investment is safe from loss, and guaranteed to grow.  The contract will state the minimum amount you can expect to receive at the end of the surrender period.

Tax Deferral- Like all annuities, your money grows on a tax-deferred basis.

Account Step Ups- In most cases, a new base contract value can be locked in when the index performs well.  This gives you the benefit of locking in a new guaranteed basis when the market works the way we all want it to.

Cons

Low Cap and Participation Rates-  Poorly constructed index annuities will not have beneficial caps and participation rates.  It’s critical to know what the objective if your investment is to ensure you get the right type of contract for your needs.  Growth oriented fixed index annuities have better cap and participation rates than income oriented ‘hybrid’ annuities.

Long Surrender Periods- Again, poorly constructed contracts have long surrender periods.  Let me state for the record that I have yet to see a good indexed annuity with a long surrender period.  For instance, one of my favorite products in this category has a five-year surrender period.  If you happen to really like it after five years, then buy it again and make it a ten-year strategy.  If it doesn’t work that well then you’re money is free a lot sooner.

Complex Crediting Methods- Using obscure or proprietary indexes or hard to understand crediting methods just makes it hard to understand the annuity.  Try to keep it simple so you can monitor performance and understand what happens on the account.

USING FIXED INDEX ANNUITIES FOR RETIREMENT INCOME:

Fixed index annuities offer partial participation in the growth of an external market index in exchange for a principal guarantee.  Since account values of fixed index annuities only move up or go sideways, consumers escape the volatility that has hammered other investment accounts in the past.

To be fair and honest, fixed index annuities are not as much of an alternative to securities as they are an opportunity for greater growth on safe money assets.  For the risk averse, they can be a great way to safely accumulate retirement assets and for others it is a good option for allocation of conservatively placed assets.

In addition, fixed index annuities carry an option for guaranteed lifetime income riders that offer some of the highest levels of future guaranteed income in the annuity market.  This will allow consumers to establish a base level of retirement income so volatility in other high risk assets doesn’t have such a negative impact on retirement plans.  These types of contracts are typically referred to as ‘hybrid annuities‘

THE VARIOUS FIXED INDEX ANNUITY RATES:

Declared Fixed Rate- Most index annuities offer the option for a simple fixed rate that is exactly like the rate offered in a plain old fixed annuity. Each contract will note the current declared rate, contractual minimum renewal rate or specify that the rate is guaranteed for the entire time period.

Participation Rate- This tells you the percentage of the associated market index that will be credited to the account when asset values are locked in.

Cap Rate- This indicates the maximum amount of interest that will be credited to the account when asset values are locked in.

** Pertaining to Cap and Participation rates, asset values typically lock-in annually but can do so in several other annual time periods as specified in the contract. This is called a contractual reset which can range from one to ten years.

Guaranteed Income Growth Rate- One of the more popular additions to fixed index annuities in recent years is the opportunity for guaranteed lifetime income regardless of account performance. With this option, the account value will grow only when the market does while the income benefit is guaranteed to increase at all times. This affords the contract owner of some level of certainty as to what level of retirement income to expect.

Death Benefit- Many fixed index annuity contracts offer an optional death benefit. With this the contract owner is guaranteed the greater of the account value or a guaranteed annual percentage increase at death.

Payout Rate- When the option for guaranteed lifetime income is elected, payments will be calculated based on the age of the contract owner and joint annuitant if applicable. Different payout rates will be available based on these factors an expressed as a percentage of the guaranteed income benefit or account value, whichever is greater.

This index annuity calculator neatly illustrates the power of the annual reset and index-linked crediting strategies utilized in Index Annuities.

Utilize the start years on this calculator to see how an account would have performed over many many years.  It’s just amazing to see.