By Dan Schulte, Senior Vice President and Manager, Annuities & Insurance
With the backdrop of market volatility, the Covid-19 pandemic, rising interest rates, high inflation and the war in Ukraine, there is certainly a lot to worry about. As a result, there has become a demand for investment products that offer a balance of protection and growth.
Fixed indexed annuities are contracts issued by insurance companies that can offer principal protection with growth potential based on movements of specific indices, such as the S&P 500. The dollars are not specifically invested in an index, but rather the annuity company will credit interest based on movement of a selected index. On the downside, fixed indexed annuities typically offer a 0% floor, meaning the worst the investment can do is not grow at all and stay the same. On the upside, each index selected in the annuity contract will be applied to a crediting strategy, that will typically limit the return on the upside – based on performance levers called caps, participation rates, and spreads.
- Rate cap:The rate cap is the maximum rate the contract can earn over a specific time period. For example, if a contract offers a 7% rate cap over a 1-year period for the S&P 500, that’s the max return that can be credited. So even if the index earns 10% in returns over the 1-year period, the most that will be credited in the indexed account is 7%.
- Participation rate:Participation rates do not typically have a cap, but rather will credit based upon a certain percentage of the growth the index experiences. For example, if a strategy has a 60% participation rate, and the specified index grows by 10%, then 6% would be credited in returns.
- Spread: Spreads are the percentage that is subtracted from the index change before interest is calculated. For example, if the applicable index increases by 7% and there is a 2% Annual Spread, the interest credited would be 5% after a 1-year period.
Usually there are several index strategy options to pick from, and policyowners can allocate their dollars to more than one. In most fixed indexed annuities, there is also a fixed interest account that will provide a specific rate of interest that will be earned. Fixed indexed annuities typically do not have implicit fees, however you may have the ability to purchase guaranteed lifetime income benefits or guaranteed death benefit riders which would incur a fee.
Annuities are tax-deferred, retirement savings products, so as a result, the withdrawal rules are somewhat restrictive. Contracts typically will have substantial withdrawal charges if you take more than the free withdrawal amount (usually 10%) in the early years of the contract (typically the first 5 to 10 years). In addition, the IRS will charge you a 10% early withdrawal penalty if you withdraw from your account before you turn 59½ years of age. As a result, you should be sure that your liquidity needs are considered prior to the purchase of an annuity.
Annuities can be complex products, and each contract is different. Be sure to work with your financial advisor to educate you on product specifics to determine if a fixed indexed annuity product is right for you
Benjamin F. Edwards does not provide legal or tax advice, therefore it is also important to consult with your legal and tax professionals for additional guidance tailored to your specific situation.