Annuities are financial products that some advisers intensely criticize and others highly recommend. But the big question is, are they right for you?
Annuities may seem complex, largely due to the fact that there are a variety of product types and options. On one side of the spectrum lie high-fee, high-risk, high-potential-gain variable annuities, where your returns rise and fall with the stock market. On the other side of the spectrum are steady, CD-like fixed annuities that generate a fixed rate of return. But there is one type of annuity that can offer you the best aspects of each: the fixed index annuity.
What Are Fixed Index Annuities?
An FIA is a contract between you and an insurance company where you give the company a certain amount of money for an agreed-upon period of time, and your return is based on the performance of a chosen stock market index, or indexes. With FIAs, your principal is guaranteed, meaning that even if the chosen indexes are down at the end of the year, you cannot lose money.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
Clients always ask me: What is the catch? How can you not lose money with an FIA when the market is down? One answer is that the insurance company is keeping your money for an extended period of time and can reinvest it. Another answer is that some FIAs can limit your total returns by using caps and participation rates.
A cap is simply a ceiling — that is, the highest percentage of interest you can gain, regardless of how the index performs. In other words, you forgo any gains that exceed the cap. With participation rates, the amount of interest you earn is a percentage, predetermined by the insurance company, of the total gains of the chosen index.
For example, let’s say the insurance company sets a 50% participation rate for a stock market index like the S&P 500. If the S&P 500 grows by 10% that year, you would receive 50% of that, or a 5% return on your investment.
Your FIA’s index rates are locked in for the duration of the chosen index, usually one or two years. Those rates can increase or decrease during the life of the contract, according to the company’s discretion, oftentimes reflecting the current interest rate environment—this is called the FIA’s “renewal rate.”
What Are the Benefits of Fixed Index Annuities?
The main advantage of fixed index annuities is their protection from downside risk. As many of our clients approach retirement and are no longer accumulating assets, they do not want 100% of their portfolio to be down if the market has a bad year.
Another big advantage is the annual lock, or reset feature, in which you lock in your gains when the annuity’s index has had a positive return. The growth is then locked in and resets to become the next year’s beginning balance.
Let’s say you have $100,000 in your FIA, and you get a 5% return. The next year, you would begin the year with $105,000. The value of your FIA can only go up or sideways — never backward. That is to say, even if the value of the index later decreases or flatlines, your annuity doesn’t lose any money, and you can never fall below your new $105,000 floor, in this example.
You can also use FIAs to generate an income stream in retirement. Almost all FIAs allow you to withdraw 10% of your account value without penalty after the first year. Additionally, some FIA products that include an income rider can generate an income stream for life, which we call a private pension.
Using FIAs for income can be attractive if you have an “income gap” in retirement, meaning your fixed income from Social Security and/or pensions is not sufficient to cover your monthly budget. Using an FIA in this manner can protect your investments in the stock market from having to be liquidated in a down market to generate a monthly cash flow.
Another advantage is that many fixed index annuities have no fees whatsoever assessed to the owner.
What Are Their Drawbacks?
While FIAs can be an excellent means of accumulating safe money, they are not silver bullet financial products. As is the case with all annuities, FIAs have a surrender schedule, which is a set period of time before an annuity’s maturity. If you sell or withdraw money from your annuity before that time window is complete, you have to pay a surrender penalty.
For example, if you have a 10-year surrender plan, you are giving your money to the insurance company for 10 years. With that in mind, FIAs offer less liquidity than some other financial products.
Moreover, because of the caps and participation rates associated with them, FIAs cannot compete with the upside earning potential of the stock market. If the market is doing well, money in the stock market will always outperform an FIA.
The Bottom Line
At the end of the day, there is no perfect investment vehicle. If there was, I would be out of business! However, if you want a reliable source of safe income in retirement, FIAs might be the ideal financial product for some piece of your portfolio.
Of course, don’t just take my word for it. Having a one-on-one conversation with a financial adviser is the best way to determine if FIAs are the right investment vehicle for you.
-
Trump's 'Revenge Tax': Are Jobs and Your Retirement Savings at Risk?Tax Law Republican lawmakers proposed a retaliatory tax on foreign investors that experts warn could lead to job losses in the U.S.
-
Where to Invest in the Back Half of 2025The crystal ball has gone dark on Wall Street. Flexibility and diversification will be key in the second half of 2025.
-
A Wealth Adviser's Seven Savvy Tips on Alternative InvestmentsBefore taking the leap into investments outside the usual realm of stocks and bonds, make sure you take these seven points into consideration.
-
What to Do After Losing Your Spouse: An Expert GuideSome financial decisions need to be made sooner rather than later. In honor of International Widows' Day, here's what you need to know about gathering documents and contacting government agencies and financial institutions.
-
I'm a Financial Planner: This Is the Key to Successful Retirement PlanningYou have to focus on what you can control — the inputs — and not obsess over what you can't control — the output. Here's how to do that.
-
Summer Is Made for Sun, Fun … and Estate Planning ConversationsNow is the time to discuss estate planning with your loved ones to ensure the Great Wealth Transfer is efficient, tax-aware and in line with your legacy goals — not Uncle Sam's.
-
Don't Have an Estate Plan? Six Things That Could Go Very WrongBad things can happen when you're unprepared, such as big-time taxes and family turmoil. Generational planning can help protect the people you love. Here's some expert advice to help you out.
-
A Financial Planner's Tips for Teaching Kids About Wealth Without Creating EntitlementIf your kids are likely to inherit and you're worried about how they'll manage, start talking about money and teaching common-sense habits as soon as you can.
-
The $1 Million Retirement Question: Are You Being Tax-Smart About Your Pension?A financial planner raises some key considerations for navigating retirement with a pension and recommends four strategies.
-
The Costly Mistake You Might Be Making With Your First 401(k)Most people start contributing to their retirement savings later in life. That could be a big-time mistake, literally costing you thousands of dollars.
