The reasons to consider a fixed indexed annuityArticle added by Jason Kestler on February 10, 2011
Ranked: #29 (1,405 pts)
There are five excellent reasons to consider a fixed indexed annuity as a component of your retirement income plan. An insurance carrier is able to provide each of these five advantages to you as long as you are able to make a time commitment to the carrier.
Possible reasons to consider a fixed indexed annuity
The foundation upon which these advantages are provided
- Safety from market losses
- Growth potential
- Tax advantages
- Income guarantees
- Beneficiary planning advantages
Possible additional benefits
- A time commitment during which you will have limited liquidity
Safety from market losses
- Up-front premium bonus
- Return of premium features
- Bailout features
If you are like many people, your top priority when you are saving your money is safety. No one puts their money in a place where they expect to lose it. We put our money in a place where we expect to get it back one day, hopefully with some nice growth.
The great thing about fixed indexed annuities is that they offer multiple levels of protection, which makes them the gold standard of safety.
1. First, when you decide to place your money with an insurance company, they must set aside a percentage of that money in reserves, that is, in very safe assets.
2. Second, by contract, a fixed indexed annuity guarantees your principal is protected and you can get it back again. There can be a penalty for early withdrawals above a certain amount, but as the annuity owner, you can control your withdrawals. So, as long as you are not withdrawing more than the penalty-free withdrawal amounts allowed by the annuity you have chosen, you cannot lose any of your principal.
3. Third, if you have a problem with the carrier that issued your annuity and you want to get a regulator involved, no matter where that annuity carrier is located, the regulator of that carrier is located in your home state. Here, annuities even beat money in the bank. Since most banks are regulated at the federal level, your bank’s regulator may be in Washington, D.C. Your annuity carrier’s regulator is much more local. You can learn more about the role your state regulator plays in ensuring that your carrier remains able to meet it obligations at the website of your state insurance department.
With these three levels of protection, there is excellent safety in a fixed indexed annuity.
Once you are satisfied that your money is protected from market drops, your next objective may be to have your money grow. The annuity industry invented fixed indexed annuities precisely so that they could offer the potential for better growth potential by having the credited interest rate based on the movement of an outside market index.
Fixed indexed annuities do this:
This combination of upside potential and downside protection is very powerful.
The illustration below shows how this combination works on a typical fixed indexed annuity. Years that the index increases in value are shaded in green, and notice that in these years, the annuity credits interest based on the increase in the index. Years that the index decreases in value are shaded in yellow, and notice that in these years, the annuity does not lose any value.
- In a year when the index increases in value, they credit an amount of interest that is based on the market index increase. Features such as caps, participation rates and spreads dictate what portion of the market index increase will translate into credited interest. Thus, the interest credit is typically less than the amount of the index increase, but in general, the more the index goes up, the bigger the interest credit.
- In a year when the index decreases in value, they hold their value. Neither your principal nor any of the previously credited interest is lost in a year that the index decreases.
You want your money to grow as fast as possible, and besides having high growth potential, some sort of tax advantage helps to accomplish that goal. It often makes little financial sense to pay income taxes on money that you are not using for current income. A tax advantage can be one of the easiest ways to make your money more productive without taking on risk.
Annuities have a tax advantage, and that advantage is tax deferral. As long as you don’t touch the money in your annuity, you pay no taxes on the interest as it is being credited to your annuity. The recognition of taxable income is delayed – that is, deferred – until you withdraw money from the annuity.
In addition, you can use an annuity as the funding vehicle for IRA or Roth IRA money, although keep in mind that the Internal Revenue Code provides tax deferral to IRAs, so there is no additional tax benefit gained by funding an IRA with an annuity. Consider the other benefits provided by an annuity to determine if an annuity is the right choice for your IRA.
A key retirement planning advantage with fixed indexed annuities is that the carrier provides a guaranteed minimum level of retirement income. Over time, as interest is credited to the annuity, and as long as you are not taking withdrawals from the annuity, the amount of that guaranteed income level can only grow, not shrink.
That guaranteed income can be provided in one of two ways.
1. The first, more traditional way is called "annuitization,” where you essentially trade the cash value of your annuity for a guaranteed stream of payments. Because annuitization is a trade, it provides you with a guaranteed stream of payments, but you lose access to and control over your cash value.
2. The other way, a recent innovation in the annuity industry, is through an optional feature called an “income rider. With such a rider, the carrier provides you with a minimum guaranteed income that you cannot outlive. Every year that you wait to take the first guaranteed income payment, the amount of the guaranteed income grows by a growth percentage that varies by company and is usually in the range of 4 percent to 8 percent. Keep in mind that this growth percentage only applies to the calculation of guaranteed income, not to the amount available as a lump sum withdrawal.
These riders sometimes have a cost associated with them, usually no more than 0.75 percent of your annuity’s value annually, depending on the individual carrier and growth percentage selected. Even after you start taking the guaranteed income payments, you still have the ability to access your remaining annuity value in the event that you may need it. But keep in mind that any withdrawal above the guaranteed amount will reduce the future guaranteed level of income that is being generated. For more details and disclosures, consult the product brochure of the specific income rider you are considering.
With either option, you have the peace of mind that comes from having an assured, guaranteed income for the period you have chosen. Notice that with an annuity, you can choose to have the carrier guarantee an income that continues for the rest of your life, or for both your and your spouse’s lives, giving you a potentially excellent level of financial security.
Beneficiary planning advantages
You may be at the point in your life where you are motivated to consider what will happen to your money after your death. Annuities have some advantages that could be very helpful to some people as they plan for how to pass their money to their beneficiaries at death.
One advantage is speed. With an annuity, as long as you have a properly designated beneficiary, you can normally avoid the sometimes lengthy and expensive probate process. So an annuity can be one of the quickest ways to get money to a beneficiary after your death.
Another advantage is privacy. With an annuity, you get to name a beneficiary and avoid passing assets through your will. This can allow you, for example, to direct money to a particular child who has been very helpful to you as you have aged, while still having your will provide for an equal division of your other assets between all your children.
The foundation: A time commitment
Most people recognize that liquidity, safety and growth do not co-exist very well. For example, with a checking account, you get excellent safety and total liquidity, but most checking accounts pay little or no interest. With stock market mutual funds, you get good liquidity and hopefully a good rate of growth over time, but you are sacrificing safety because there is no guarantee that you will be able to get back what you invested when you actually need the money.
So, with financial products, there are trade-offs. You cannot get all of the most desirable features and benefits in one product. They all have a purpose and can complement each other in a well-designed and diversified plan. Since an annuity is going to give you safety of principal and growth potential, it is reasonable to assume that there has to be a trade-off somewhere, and it is with some sacrifice in liquidity.
Fixed indexed annuities require that you make a time commitment, and they enforce that time commitment by a surrender charge. When you consider buying a fixed indexed annuity, make sure you are comfortable with the length of the surrender charge, because your access to your principal is limited during the surrender charge period.
Your time commitment can typically range from three to 16 years, depending upon the features and benefits that appeal to you. The time commitment does not mean that you do not have any access to your funds. Many annuity products allow earned interest to be taken after 30 days and others allow up to 10 percent of your annuity’s value to be taken each year after the first year without penalty.
Of course, if you do not need your funds, leave them in the annuity to accumulate on a tax-deferred basis until you decide to begin taking income payments.
This is contrary to bank certificates of deposit that typically only allow interest to be withdrawn and will impose an early withdrawal penalty for any principal withdrawn. So to be able to enjoy the unique benefits that annuities provide, you have to allow the insurance company to hold your funds just like you would allow a bank to hold your funds.
With annuities, just as with certificates of deposit, there is generally a correlation between the time commitment that we allow the institution to hold our money and the productivity of our funds. The longer we commit to letting the bank or insurance carrier hold our funds, the higher the rate of interest or upside potential we can enjoy. A 5-year certificate of deposit will usually pay us a higher rate of interest than a 1-year certificate of deposit. The same principle holds true with a fixed indexed annuity. A 10-year product, for example, will typically offer a higher fixed interest rate and higher indexed-based interest crediting than a 5-year product.
If you take out more than the penalty-free amount (which varies by carrier and product), there can be substantial surrender penalties imposed (perhaps as high as 20 percent of the annuity’s value for a premature withdrawal), so you want to use an annuity as a part of an overall plan where you also own other accounts that have no surrender penalties for your short-term liquidity needs. Use these other accounts for emergency funds and to pursue financial opportunities that arise.
Remember, annuities are designed to provide safe growth prior to retirement and guaranteed income streams during retirement. They are not designed for short-term liquidity. You will want to have sufficient funds for that purpose in other accounts, such as checking, savings and money market accounts.
Choose fixed indexed annuity products for a specific purpose, such as principal-protected growth and income generation, where 100 percent liquidity is not needed during the surrender charge period. Once the surrender charge period is over, you can withdraw any and all of your money from the annuity at any time without a surrender penalty. Keep in mind that withdrawing money from an annuity will usually result in reporting of taxable income and, if taken prior to age 59½, may result in a 10 percent penalty tax on earnings.
Possible additional benefits
The annuity marketplace is very competitive, and thus carriers often have attractive additional features designed to differentiate their products from the competition.
Some fixed indexed annuities have features such as these noted below:
In summary, you can see that annuities offer a lot of positive features – safety from market losses, growth potential, tax advantages, income guarantees, and beneficiary planning advantages – all built on the foundation of the time commitment that you make to the carrier.
- Up-front premium bonus: Some annuity products have a premium bonus that immediately bumps up your contract value. The percentages will vary by carrier. But for example, if you put $100,000 into an annuity that offers a 5 percent premium bonus, your contract value on day one will be $105,000. This premium bonus is available to earn interest right from the inception of the contract. You are not, however, allowed to withdraw the premium bonus right away. The premium bonus is often subject to recapture charges if you take withdrawals above the penalty-free withdrawal amount in the early years of the contract. In other words, what we said earlier about the time commitment applies to the premium bonus, too. Keep in mind that premium bonus annuities may include lower cap rates, higher spreads, or other limitations that are not found in annuities that don’t have a premium bonus feature.
- Return of premium features: All fixed indexed annuity products have surrender charges, and so with most of them, you actually can lose money if you cancel the contract during the period where the surrender charge applies. Again, if you abide by the time commitment, the surrender charge reduces over time and ultimately disappears, so you receive your principal plus all credited interest with no risk of loss. But some carriers differentiate their products by providing that even if you choose to terminate your annuity contract early, you are guaranteed to receive back at least what you paid in.
- Bailout features: Some carriers provide for the surrender charges to be waived in case of certain hardships, such as if you are diagnosed with a terminal illness, or become confined to a nursing home, or even if a renewal rate or cap rate falls below a certain level on your annuity.
The views expressed here are those of the author and not necessarily those of ProducersWEB.
Reprinting or reposting this article without prior consent of Producersweb.com is strictly prohibited.
If you have questions, please visit our terms and conditions