One of the biggest challenges facing people preparing retirement is maintaining a steady stream of income after work ends. You will generally need some form of growth in your retirement account to ensure you do not run out of money, but you also need to temper risk while in retirement. Avoiding investment losses is extremely important for retirees.
Traditionally, people think they have only two strategies when it comes to retirement income. In the first, you put funds in a certificate of deposit or savings account to keep the money safe while accepting that the low interest rate may not keep pace with inflation. In the second, you stay invested and accept the risk for returns that will hopefully at least keep pace with inflation.
While these two options are the most common, the market has introduced new financial vehicles in recent years. These options could help balance risk and return more effectively.
One such option is a fixed indexed annuity policy, an insurance company product that provides some growth while protecting against market crashes. Fixed indexed annuities allow investors to participate in the growth of an index, such as the S&P 500, without exposing the principal to excessive risk. These policies come with a no-loss guarantee so investors can ensure that they do not put themselves at a disadvantage inadvertently.
How Does a Fixed Indexed Annuity Minimize Account Losses?
While the product contains the word indexed, the funds are never actually placed in the market. Instead, the money is put in an account that mirrors market growth and protects against market loss. The rate of return of a fixed indexed annuity is called the participation rate. As the policy owner, you get to keep the participation rate as growth gets credited to the account. While the participation rate limits growth, it is a trade-off for avoiding market losses. Furthermore, some fixed indexed annuities have participation rates exceeding 100 percent.
The idea of a participation rate can be somewhat confusing, so it is helpful to work through some examples. Suppose the participation rate for a particular fixed indexed annuity is 90 percent, and the S&P goes up 10 percent. The principal would receive a credit of 9 percent. However, if the S&P goes down by 40 percent in the same period, then the account loses nothing.
It’s important to pay close attention to participation rate when shopping for annuities. However, you should also ask about fees tied to the policy, such as rider and allocation fees. Also, annuities generally have surrender charges for liquidating an annuity early. All of these factors work together to generate a return. Since annuities quickly become quite complex, it’s a good idea to consult a finance or insurance professional when purchasing an annuity.
How Do Insurance Companies Make Money with Annuities?
Savvy investors may wonder how insurance companies make money off of annuities if they offer growth potential without the chance of losses. A small portion of the funds used to purchase a fixed indexed annuity is invested in call options so that the insurance company can achieve market-linked growth. The cost of call options, in turn, determines caps and spreads, as well as participation rates. Much of the money involved in an annuity purchase is invested in bonds, and the insurance company makes money through the difference between bond yields and the cost of call options. Understanding caps and spreads is important for explaining how insurance companies profit from annuities.
Caps limit the amount of money an investor can make from a particular index. The annuity provider may cap returns at 8 percent, which means that even if the index returns 12 percent in a year, the investor only gets 8 percent and the insurance company receives the rest. A spread is a baseline over which the investor receives a credit. For example, if an annuity has a spread of 4 percent for a given index, investors only get credit for what is earned beyond the spread. If the index gains 6 percent, the investor receives a 2 percent credit. However, if the index gains only 2 percent, the investor gets no credit. This strategy helps guarantee income for the insurance company.
Participation rates are another way that companies get an income from annuities. Indexes tend to have locked caps, spreads, and participation rates.
What Are the Potential Downfalls for Investing in Annuities?
One of the biggest issues with fixed indexed annuities is that they are not backed by FDIC insurance as most other investments are. If the insurance company holding the annuity goes bankrupt, you lose your investment outright. Luckily, insurance companies are rated based on their resilience, so you can seek out companies with the highest rating (A+) only. Importantly, choosing a company with a higher rating minimizes the chances of loss, but it does not make it go away completely, so there is still some risk involved.
The other issue you need to consider is the lack of liquidity with an annuity. Surrender charges can be quite high to discourage people from liquidating the account early. Annuities pay out for a fixed period, which can be up to 10 years. If a better deal or new product comes along in the meantime, you will not be able to take advantage easily. Thus, fixed indexed annuities are most beneficial for people who do not mind giving up liquidity for the peace of mind provided by the investment.