Fixed Index Annuities: How They Work and Things to Consider
You may never have considered a fixed index annuity, but is it something you should look at for your retirement plan?
Many people think annuities are too complicated. That’s why throughout our “Annuities – Why Ever Use Them” series, we’ve tried to answer the questions which may have led you to dismiss them in the past.
In this post, we’re focusing on fixed index annuities, specifically how interest is credited on them. We’ll also recap some general advice on annuities, so you can stay informed about how they work and what they can offer.
What are annuities? A quick recap
If you’re unsure what annuities are, how they work and the benefits they offer, be sure to go back to part one and two of our “Annuities – Why Ever Use Them” series. It’s worth understanding the basics before we launch into the more complex areas of deferred fixed index annuities, which we’ll cover in this post.
As a quick recap, here are some key points to be aware of:
- Annuities are generally used for one of two reasons: as a safe money alternative or as a fixed source of income in retirement.
- There are two main types of annuities: immediate and deferred.
- Immediate annuities are when an insurance company sets up an income stream based on your retirement assets.
- A deferred annuity is used as both a safe money alternative and an income stream.
- Deferred annuities have two types: fixed and variable. We wouldn’t recommend variable, as there’s a risk you could lose money.
- Instead, we always suggest declared rate or fixed index deferred annuities.
- A declared rate annuity offers a fixed rate of return over a set period; it’s often compared to a bond or a certificate of deposit (CD).
- A fixed index annuity is when the rate of interest you earn varies in line with an index, such as the SMP500. This is a great option because you can benefit from upswings in the market without the risk of losing money.
We appreciate that’s a lot of information to take in. If you’re at all confused by how different types of annuities work, we’d encourage you to read parts one and two of the “Annuities – Why Ever Use Them” series.
Alternatively, listen to episode 26 and episode 30 of the Securement Your Retirement podcast, where we cover these topics in detail. They’re available on your usual podcast app or on YouTube.
What is an index cap and how does it affect a fixed index annuity?
Now we’ve covered what you need to know about annuities, let’s continue our conversation about how interest is credited on a fixed index annuity.
In part two of “Annuities – Why Ever Use Them,” we talked about the annual reset and how it relates to the interest you earn. Think of this as a reset point for the interest-earning period; it varies depending on the terms of your contract but usually happens every 12 months.
The beauty of a fixed index annuity is that any interest you earn is guaranteed and will be credited to your account on the annual reset. This then becomes the starting point for the new interest-earning period.
However, there are a couple of other things to note about interest crediting on a fixed index annuity, including the “index cap”.
The index cap is the maximum amount of interest you can earn in an interest-earning period, as a percentage sum. It’s set by the insurance company who controls your annuity and is based on a range of factors, including the overall financial outlook.
To help you understand how an index cap works on a fixed index annuity, here’s a simple example:
- You put $100,000 into a fixed index annuity
- The insurance company sets a 5% index cap
- The index performs well over your interest-earning period and is up 15%
- The index cap means you’ll make 5% interest
- The interest is credited during the annual reset
- You now have $105,000, which is guaranteed and will never fall
This is just a simple example to show you how the index cap dictates the interest you earn on a fixed index annuity. Whether it’s the SMP500 or the NASDAQ; no matter how strongly an index performs, you’ll only earn interest up to the index cap.
It’s worth remembering that you can’t lose money on this type of annuity, even if the index performs poorly or goes negative. Any interest made is guaranteed, so whatever you earn is yours to keep – making a fixed index annuity a powerful way to grow your retirement fund.
What is the participation rate and why does it matter?
Something else that affects the interest you can earn is what we call the “participation rate”. This is a percentage sum, set by the insurance company, which essentially decides how much money you should make from an index.
To show you how the participation rate works and how it affects the interest you’ll earn on a fixed index annuity, here’s a basic example.
Let’s say you pay $100,000 into a fixed index annuity with a 50% participation rate. This means you’ll earn 50% of what your index makes.
So, if an index made 10%, you’d get 5%. If it made 12.5%, you’d make a 6.25% return.
Participation rates vary widely and are one of the first things we look for when finding the most lucrative fixed index annuity deals. Insurers offer lots of different rates, with the majority falling in the 80-90% range, though they can be higher or lower based on a range of factors.
Do you want to put your money in a fixed index annuity? We can help
The world of fixed index annuities can be complicated, with lots of options and things to consider. But if you think this sounds like the right direction to take with your retirement plan, we’re here to help.
Our experts have years of experience in helping people set up and manage a fixed index annuity. And with the potential to boost your retirement assets by a considerable amount, taking advantage of our knowledge and expertise is certain to be worth your while.
We’d also like to reiterate that while annuities may sound complicated, they have been around for a long time, with billions of dollars passing through them each year. Through our “Annuities – Why Ever Use Them”series, we want to get you thinking differently about these products, so you can make an informed decision on where to put your retirement assets.
Are you ready to take the next step on your retirement plan? Book a complimentary 15-minute call with a member of our team to discuss your retirement goals today.