Are Fixed & Indexed Annuities Low-Risk Investment Alternatives?

If you’re like many people, your understanding of how an annuity works probably looks something like this: You give an insurance company a sum of money, and the insurance company returns the funds to you as a monthly payment for the rest of your life. While accurate, that understanding encompasses only what are referred to as immediate annuities – there are other types available that may be more beneficial in certain circumstances.

One such option is a deferred annuity. Here, the idea is, you’ll turn the balance of your investment into a stream of payments at some point in the future, but until that happens, you would like to use the options offered by the insurance company to grow it. Examples of deferred annuities include fixed, indexed, and variable. Many people use fixed and indexed annuities to potentially earn more than they could in a bank account, without subjecting themselves to the fluctuations experienced by the markets. Many also use deferred annuities for their potential returns, without ever having the intention of annuitizing the balance in the future.

Based on historical precedent, over a long period of time, an investor would expect to earn more by putting his or her money directly into the market, without including an insurance company in the mix. However, markets are subject to volatility, and corrections, bear markets, and recessions can by psychologically challenging to live through. For those seeking a calmer ride, the choice is either keeping the funds in a bank account or using a fixed or indexed annuity, and using an annuity could make sense as a means of potentially increasing earned interest.

Fixed Annuities

A fixed annuity is a type of deferred annuity, where you agree to a time commitment of a period of years and the insurance company agrees to pay you a fixed rate of return for that amount of time. These rates are usually more favorable than bank CD rates; however, the penalty for early withdrawals is most likely higher. Once the term is complete, you will most likely be offered a new rate for your account, and you can then decide if you would like to keep the funds with that insurance company or move them elsewhere. 

Indexed Annuities

An indexed annuity generally pays an interest rate that is dependent on the performance of a specified market index, such as the S&P 500. Generally, the insurance company guarantees the amount deposited to the account, so it does not lose value. An example of this payout structure could include receiving the return of the index over a one-year period, but with a cap at a specified rate or certain percentage of market return over that period. 

If the index has a negative return over the specified term, the risk is generally that you would not be credited any interest for that period of time. Given the historical performance of the specific index, you may expect to earn more using an indexed annuity than you would in a fixed annuity; however, since the return of the account is dependent on the performance of the underlying index, it is not guaranteed. Generally, indexed annuities have a time commitment of at least five years.

Other Considerations

If you decide to explore the world of annuities, there are some things you should keep in mind. Annuities are not FDIC-insured, so when comparing your options, you probably also want to consider how well the various insurance companies are rated. Since the intent for a deferred annuity is eventually to annuitize the contract, many insurance companies do not issue new contracts to individuals over age 85. Earnings received in a deferred annuity held outside of a retirement account are taxed as ordinary income when withdrawn from the account, and taxable earnings must come out first, prior to accessing your original deposit. Withdrawals from an annuity prior to age 59.5 can also include a 10% penalty from the IRS. 

Annuities can also layer on various other protections called riders, which can offer additional benefits like guaranteed income payments or long-term care benefits. Annuities can be complicated, so it’s important that you understand the terms you’re agreeing to, along with how those terms benefit you and your specific goals for the funds.

Hopefully, this helps to take some of the mystery out of fixed and indexed annuities. If you are interested in potentially earning more than you can in a bank account, without subjecting your balance to market fluctuation, these could be account types to consider.

To learn more about annuities and gauge whether they might be the right option for you, please reach out to me today at (608) 798-5934.