Most financial experts believe that many older Americans are too heavily invested in the stock market, and now there’s evidence to back them up. When giant Fidelity Investments analyzed its retirement account customers, it found that 37% of those born between 1946 and 1964 (so-called Baby Boomers) have more equity holdings than they should. Depending on age, people in this age bracket should have from 47% to 67% in equities, according to Fidelity.
While it takes individual tailoring to achieve the right asset allocation, having too much in stocks is risky for older people, who don’t have as much time on their side to recover from market downturns. Furthermore, retirees who need money may be forced to sell equities during downturns. Excessive amounts in stocks can cause worry.
In a previous article on asset allocation, Too Heavy in Stocks? Annuities Could Be a Rebalancing Option, I mentioned that the fixed-income asset class, including annuities, bonds and bank certificates of deposit, is where to turn if you’re overweight in equities. I covered the benefits of using a certain type of fixed annuity, the multi-year guarantee annuity (MYGA), which guarantees a set interest rate for multiple years, for part of your retirement savings.
But that’s not the only type of annuity that can reduce your portfolio risk. Other choices include income annuities and fixed indexed annuities.
How fixed indexed annuities work
Fixed indexed annuities can provide a good home for some of your retirement savings because they guarantee your principal but offer more growth potential than fixed-rate annuities or other fixed-income vehicles. They’re suitable for long-term money, where your time horizon is at least five years. Over the very long term, fixed indexed annuities are likely to produce higher returns than other fixed-income investments but lower returns than equities.
Fixed indexed annuities have a lot of moving parts. To ensure you’re getting one that suits your needs best, you’ll need to spend some time looking at your options. An experienced annuity agent can help you reach the right decision.
A type of deferred annuity, fixed indexed annuities are normally bought with a single premium with a typical minimum of at least $5,000, though some require $10,000 or more. If you use them for non-qualified money (not in a retirement account), interest earned is not taxed until you withdraw it, and you can delay withdrawal as long as you like. You can also use one in conjunction with qualified retirement accounts, notably IRAs and Roth IRAs.
Here’s why they’re unique. Fixed indexed annuities credit interest annually to your account based on annual changes to a market index, such as the S&P 500 or Dow Jones Industrial Average. You receive an interest credit when the index value increases.
But when that value decreases, you don’t lose anything. Your principal and all previously credited interest can never be lost and are always protected, even if the stock market crashes. In effect, you can have your cake — part of it, anyway — and eat it, too.
No free lunch, but still a tasty meal
Nearly all indexed annuity interest-crediting-formulas have limits so that interest earnings will usually be based on only a portion of the change in the market index over each index crediting term (usually one year). In exchange for the added guarantees and principal protection, you may not receive 100% of the index market gains.
- The cap rate sets the maximum rate of interest the annuity can earn during each index term. For instance, the cap rate on the S&P 500 index might be 12%. If the S&P 500 returns less than that, you’d get the full amount, assuming your contract doesn’t have any of the other limiting factors listed below. But you can’t get more than 12%, even if the index is up 25% over the term.
- The participation rate determines what percentage of the increase in the underlying market index will be used to calculate the index-linked interest credits during the index term. For instance, you may receive 60% of the upside.
- The spread rate or margin is the number of percentage points deducted from the change in the underlying index value to determine the net amount of index-linked interest that is credited to the annuity. For instance, your interest credit could be reduced by 2 percentage points (but can never go negative).
Many features and options
Many indexed annuities let you purchase an optional income rider that guarantees a certain future lifetime income. Terms vary.
There are generally no penalty-free withdrawals during the first year. Most indexed annuities let you take out up to 10% withdrawals in year two and each year afterward. However, the interest portion of withdrawals from non-qualified annuities is taxable.
A premium bonus is the percentage added by the insurance company to premium payments made by the annuity owner. Bonuses are frequently subject to a vesting schedule.
The fixed account rate is the current interest rate applied to the premium that is allocated to the fixed interest account. Typically, this interest rate is adjusted annually by the insurance company.
The fixed account is the portion you can optionally allocate to a guaranteed-rate account. Putting some money into it mitigates the interest-rate fluctuation you’d get if you put all your money in the market-indexed accounts. However, that move does reduce your upside potential.
How to choose an indexed annuity
Think of three primary goals:
Grow your long-term money while reducing risk. If this is your main goal, consider indexed annuities that are likely to yield the most interest possible over time. Guaranteed-income options and other bells and whistles have a cost to the insurance company, which passes the cost on to the annuity owner in the form of reduced earnings potential. They can work against your growth goal.
What else can you do to increase the odds you’ll get the best long-term return? Ranking indexed annuities by their current cap rates or participation rates helps but doesn’t provide a complete picture.
Back-testing based on historical index performance gives an idea of how a particular indexed annuity sub-account might perform in the future. While past performance is not a guarantee of future performance, it’s a good starting point.
Most back-testing assumes that the current cap rates and participation rates will remain unchanged for the entire test period. This is a bit deceptive because insurance companies can usually adjust cap and participation rates annually, and many do. Understanding a particular insurance company’s history on cap and participation rate adjustments can be helpful.
Guarantee future income. Here, you’ll want an indexed annuity with the best future income guarantees, typically via an income rider. You may be less concerned with account value growth.
This is the easiest goal to research. Some annuity agencies, including AnnuityAdvantage, have proprietary tools to compare and rank nearly all indexed annuity income riders for easy comparison.
But don’t make your decision based solely on the amount of guaranteed future income. Since you’ll be relying on the insurance company to provide income payments for your lifetime, you should also consider its financial strength.
What if two income riders produce the same income payments? Look at other factors to break the tie, including cap and participation rates. Which issuing company is financially stronger and better rated? Which annuity offers indexes that you like — is the S&P 500 the only choice, or are there other options? Which one has better liquidity provisions?
Get both reasonable growth potential and income guarantees. With this balanced approach, you will probably not get the very best growth potential or the best future income guarantees. But you should be able to do well in both areas. This will let you take advantage of both growth potential and guaranteed income, depending on how your needs develop in the future. This gives you the most flexibility. Since you’re looking at both areas, the analysis will be more complex.
Fixed indexed annuities aren’t suitable for all people saving for or in retirement. Many people prefer simpler instruments. But since they offer a unique combination of growth potential and safety, they’re well worth considering.
Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed, and lifetime income annuities. He’s a nationally recognized annuity expert and prolific writer on retirement income. A free rate comparison service with interest rates from dozens of insurers is available at www.annuityadvantage.com or by calling (800) 239-0356.
Retirement-income expert Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed and immediate-income annuities. Interest rates from dozens of insurers are constantly updated on its website. He launched the AnnuityAdvantage website in 1999 to help people looking for their best options in principal-protected annuities. More information is available from the Medford, Oregon, based company at https://www.annuityadvantage.com or (800) 239-0356.
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