An annuity is a hugely popular retirement vehicle today. It’s designed to provide retirees with income replacement. To start an annuity, you sign with an insurance company and pay premiums over several years until you retire (you pay no tax on your contributions; you only pay them when you would begin collecting). In many cases, insurance companies will accept large lump-sum payments from retirees instead of premiums over several years.
How do Fixed Index Annuities Work?
The insurance company puts your money in stocks that are currently performing well. To make sure that they pick good stocks, they follow a popular index — a list of several well-respected companies that are thought to represent the stock market overall. Usually, they follow an index such as the S&P 500 or the Dow Jones Global Titans 50. With the money made off these stock market investments, the insurance company pays you a minimum fixed income each month. There’s also the chance of making more.
The better the companies on these indices perform, the more money your annuity investment makes for you. However, if the markets perform poorly, you don’t lose money. You still get the minimum return promised each month; the insurance company absorbs the loss.
The downside of a fixed index annuity is that you pay a price for the security of knowing that your annuity investment will never evaporate with a bad stock market downturn: when there is an upswing, you don’t make much. The insurance company handling your annuity places a cap of anything between 2% and 9% on your gains and takes the rest of the profits for itself to make up for the risk that it carries.
Unfortunately, not many investors are aware of the cap (this story on Bloomberg Business is an example). Investors lock in hundreds of thousands and expect major returns only to be disappointed.
The fixed returns that you get with such an annuity are mostly cost-free. There are no separate fees or commissions to pay. In fact, these annuities are marketed as no-cost products. Nevertheless, a few costs along the way are standard.
Surrender fees: Fixed index annuities work well when you leave your money with them. If you find that you need your money a couple of years down the line, though, you’ll need to pay a penalty for it. Over the first two years, you will usually pay anything from 7% to 11% (depending on the provider).
Opportunity costs: Fixed annuities make sense when the stock markets are unreliable. At times when they are steady and strong, though, you lose significant amounts of money going with safety.
Nevertheless, Fixed Index Annuities are a Great Retirement Investment Idea
Here are some the benefits of fixed income annuities:
You defer paying tax: Until the day you retire and begin tapping your annuity, contributions made to fixed index annuities attract no tax. The interest is simply folded into your principal and is compounded annually.
You make more: Fixed index annuities make much higher interest than deferred annuities or bank CDs.
Your contributions aren’t capped: You get to contribute as much as you want to fixed index annuities. Unlike 401(k)s or IRAs, there are no limits in place.
Finally, fixed index annuities help you protect your principal. No matter what happens to the stock markets, your principal is safe.