Fixed and fixed indexed annuities have an appropriate and valuable place in your portfolio
. Let’s compare them to two other popular products — mutual funds and bank certificates of deposit — to see where they fit.
One common way to compare investment alternatives is to look at a spectrum of risk and reward, that is, a spectrum of risk
and expected return. Financial vehicles that provide substantial protections against risk are able to attract money at relatively low returns, whereas risky financial vehicles must provide much higher potential and expected returns in order to attract money from investors.
Now, let’s look at the financial vehicles we are considering. We’ll travel from safest to riskiest on the risk/return spectrum.
Bank certificates of deposit: These are clearly very safe, as the principal is guaranteed first by the issuing bank and second, up to a limit, by the FDIC. The interest rate you will earn is also guaranteed for the duration you select. If you choose to take your money out early, the penalty is typically very modest, equal to only a few months of interest. As a result of their safety and predictability, interest rates on bank certificates of deposit are usually fairly low.
: These are also very safe, as the principal is guaranteed first by the issuing insurance company and second, up to a limit, by state insurance guaranty funds. Fixed annuities are available in a range of surrender charge durations, many with interest rates that are fully guaranteed for the duration selected. Surrender charges are higher and perhaps longer than on bank certificates of deposit, which allows issuing insurance carriers to typically provide higher interest rates than bank certificates of deposit.
Fixed indexed annuities
: These are a type of fixed annuity, and thus they are very safe. The principal is guaranteed first by the issuing insurance company
and second, up to a limit, by a state insurance guaranty fund. Where they differ from other fixed annuities is that the interest rate is not guaranteed at as high a level as most fixed annuities, but the interest rate fluctuates from year to year depending upon movement of the referenced market index and the formula applied to that movement. Fixed indexed annuities can provide even better rates of interest under certain conditions.
: These are securities, and that gives you a clue that we are now entering much riskier territory. The principal is not guaranteed by anyone. The return in any one given year can be sharply positive or negative. For example, a common proxy for stock fund returns is the S&P 500 index, which rose 26 percent in 2003 and dropped 38 percent in 2008. Thus, for mutual funds to attract money, they must offer the prospect of a higher likely return than indexed annuities. Over the last century, they have done so, although over the last decade, they have fallen woefully short.
Thus, the fundamental spectrum of risk and expected return is filled in the appropriate places by fixed and indexed annuities
. They offer a higher likely return than bank CDs, but a lower likely return than mutual funds, which are much more risky. As long as you properly understand where annuities fit and make decisions on that basis, you will find that annuities are valuable financial products, and retirement savers are better off that they exist.
This article is intended as general information only and should not be construed to be investment advice. For investment advice, please seek a qualified advisor.