Today’s retirement planning journey is likely very different from what your parents experienced. Retirees can no longer rely on a large pension and Social Security check to provide for their income needs and are seeking safe investment options and saving tools. As a result, sales of annuities had a record-breaking year in 2022, led by fixed indexed annuity sales at a total of more than $310 billion.
In addition to not being able to rely on a pension and Social Security, today’s retirees face the challenge of creating an income for 20 to 30 years in retirement — much longer than previous generations. Plus, modern savers and investors are faced with extreme market shifts that wipe out previous earnings, as seen in 2000-2002, 2008, 2020 and 2022. To make matters even more difficult, bonds are usually used as a hedge against volatile markets, but in 2022, bond yields dropped in tandem with equities.
Today’s fixed indexed annuities provide principal protection from market losses and the opportunity to use a living rider benefit for guaranteed growth and lifetime income regardless of market returns. As more investors consider adding fixed indexed annuities to their retirement plan, it is important to understand the full picture of how they work, what they can provide and how to find good ones.
The 411 on Fixed Indexed Annuities
Fixed indexed annuities (FIAs) are a low-cost way to protect your retirement savings, while also offering opportunity for further growth. Some FIA accounts grow based on a combination of indexes, similar to how mutual funds mix different stocks. There are index funds linked to the low-volatility S&P 500 funds as well as U.S. and global commodities and precious metals. These index funds help provide broad exposure beyond traditional asset classes and provide an active management component, allowing the fund manager to shift amongst all the asset classes depending on current and future market conditions to maximize your yield.
Other FIA accounts mirror an actual index, like the S&P 500, which is known as a purist approach. With this type of account, your participation rate, or how much of the earnings you get to keep, can be up to 60% with principal protection.
Although it may seem like a participation rate below 100% limits your earning potential, it does not outweigh the benefit of avoiding downside risk. To illustrate this, imagine you bought $100,000 worth of stock in the S&P 500 in 2000. At the same time, your neighbor put $100,000 into an FIA offering a 40% participation rate on the S&P 500 price index. You both need $5,000 of income each year.
Although you get to keep 100% of your earnings in the stock market, you would have also experienced every ounce of volatility seen over the last two decades. Your neighbor’s FIA account does not experience downside risk because it provides principal protection. By 2022, your S&P 500 investment would have been worth $33,402 after taking your early income. Despite a 40% participation rate, your neighbor’s FIA would have earned $57,575 even after taking their yearly income. That's a difference of over $24,000!
How to Use an FIA
People generally use FIAs in one of two ways. The first way is meant to accumulate retirement income with no risk of losing your principal. In this instance, once your FIA surrender period ends, you can take your money and any earned interest out or use the account value to help supplement your retirement income. Even if you need some of the annuity money before the surrender period is over, you can withdraw up to 10% from the account penalty-free. This version of an FIA does not charge a fee.
Alternatively, an FIA can be used to create guaranteed growth and a guaranteed stream of income in retirement that lasts for one or two lifetimes by adding a living benefit rider. You still get all the benefits of a non-living benefit rider annuity (principal protection with a fixed account and market participation through index funds), but you have the added benefit of guaranteed growth and guaranteed income to protect against market volatility.
A living benefit rider typically charges a 1% to 1.25% fee, which allows you to create a “personal pension” for retirement. At the very least, you know how much guaranteed income you will have in retirement, but if the index funds tied to your FIA have good market performance, your income and account value can be boosted!
Besides these two main purposes, purchasing an FIA can meet a number of retirement goals. An FIA can help you fight against sequence of returns risk by protecting you from downside market risk. An FIA with a living benefit rider can fight inflation risk by providing guaranteed growth regardless of market performance. Some FIAs even offer a guaranteed increase on lifetime income whenever the consumer price index (CPI) rises. An FIA can even provide a death benefit to leave as a legacy.
How to Find a Good FIA
No two annuities are the same, so while shopping for an FIA, keep these tips in mind:
Duration, participation rates and cap rates. Insurance companies set participation rates and cap rates for FIAs to offset their own risk, so be mindful of how those rates will affect your earning potential. In the last decade, FIA carriers have begun offering participation rates above 100%. The longer you are willing to wait to receive your earnings, the higher your participation rate can be.
For example, a carrier may offer a 100% to 150% participation rate if you are using a one-year index strategy. But if you wait two years before your earnings are determined, you could get 200% to 250%. Adding more duration to an annuity can be beneficial, because higher participation rates can boost your returns during low-yielding markets.
Cap rates determine when your earnings are “capped” or maxed out. For example, a carrier may offer an FIA with a 10% cap rate on the S&P 500. If the S&P 500 earns 7%, you get 7%. If it earns 12%, you earn only your cap rate of 10%. Carriers will offer a range of participation rates and cap rates, so compare a wide variety of annuity products before making any decisions.
Expert insight. If you're looking to add annuities to your overall financial plan, make sure you work with a knowledgeable independent financial adviser with access to any annuity products rather than a limited line-up. They should be able to sell any annuity in the marketplace. Otherwise, your choices can be severely limited, and you may not get the best solution for your retirement.
As you and your adviser search for the best options for you, be especially mindful of the illustrations being provided by insurance companies to highlight the earning potential of their products. Carriers are required to show you an illustration of a 0% market gain to highlight the “worst-case scenario” of how an FIA would perform. They also have to provide an illustration of how an annuity would perform using the most recent 10-year market run.
The issue with this illustration, though, is that most of the past decade was a bull run on Wall Street. Look for the page in the illustration that shows the best and worst 10-year performance over the last two decades. Use the worst 10-year run to compare the earning potential of annuities, rather than making your decision based on the “best-case scenario.”
As long as you consider your options carefully with a trusted financial professional, adding an annuity to your retirement plan can bring immense peace of mind as you plan for and enjoy your golden years.
Bradley Rosen is the owner and president of Longevity Financial, an independent financial professional with over 24 years of financial planning experience. Bradley provides each client with a customized Design for Life By Longevity FinancialⓇ plan that encompasses each part of their financial picture, including investments, insurance, taxes and legacy planning. He is passionate about creating longevity with one’s finances and prioritizing holistic health, both physically and financially. His unique approach to retirement planning is the result of watching both his grandmothers outlive their retirement income. For his dedication to educating and empowering women, he was awarded the Thelma Gibson Award in 2015. He has been featured in Forbes and on the local CBS, NBC and FOX TV news affiliates in his new hometown of Atlanta.
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