The Fixed Index Annuity: Recession-Proof Your 401k and IRA

Shawn Plummer

CEO, The Annuity Expert

What is a fixed index annuity? This guide will explain everything a fixed index annuity can provide when saving before and during retirement. This is ideal for:

  • Moderate and conservative investors wanting safe stock market growth for their 401(k) or IRA with added protection from a stock market crash.
  • Consumers wanting to guarantee a future fixed income starting today.
  • Investors wanting to receive regular income in retirement for as long as they live.
  • New retirees wanting their savings to continue to grow while providing regular income.
  • Investors wanting to lock in their interest so they can leave money to their heirs.
  • Pre-retirees that have maxed out their 401(k) and IRA and want to save even more with tax deferral.

What is a Fixed Index Annuity?

A Fixed Indexed Annuity is a type of fixed annuity that allows a consumer to earn interest based on the performance of a stock market index such as S&P 500, Dow Jones, and Nasdaq. This insurance-based, tax-deferred retirement plan means fixed index annuity owners can’t lose money due to stock market volatility and downturn.

You can only lose your retirement savings to fees and spending down the account.

If a traditional fixed annuity and a variable annuity had a baby, I’d like to think the fixed index annuity is that baby.

Fixed index annuities are considered an insurance-based, tax-deferred accumulation retirement savings plan. They are not investment products. Instead, those are called variable annuities. Unlike a variable annuity, you can not lose your money to stock or bond market volatility.

Other names for an FIA are:

How does a Fixed Index Annuity Work?

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The Accumulation Phase

Fixed index annuities are designed to help protect your retirement income from risks like stock market exposure outliving your money. An indexed annuity does this through a combination of benefits that shield your money from market downturns while allowing for growth opportunities to earn interest. These interest credits are tied to increases of a popular index, such as the S&P 500.

A fixed index annuity is designed to protect and grow your retirement savings to build up assets for the future or provide a guaranteed income later in retirement.

The Income Phase

The income phase is an optional phase with a fixed index annuity. If you choose to utilize the income option, the money that has been credited to your contract can be turned into an income stream that can last a lifetime. The income can be generated through annuitization or a fixed indexed annuity with a guaranteed income rider.

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Key Takeaway

A fixed index annuity guarantees that you’ll never lose money due to market performance because your money is not directly invested in the stock market and offers several ways to earn interest that are linked to an index like the S&P 500 index.

Your interest earned is based on the positive movement of an index between 2 specific dates, including upward movements during a Bear Market.

Fixed Index Annuity Pros and Cons

The Pros

Protection from Market Volatility

A fixed index annuity allows you to participate in positive market performance and lock in gains. In addition, the account value is protected, even when the stock market declines.

Tax-Deferred Growth

Owners don’t pay ordinary income tax on earnings annually like a certificate of deposit (CD). Instead, fixed deferred annuities offer tax deferral, which means you can earn interest on your initial investment, earned interest, and the money that normally would go to the IRS. This is called triple compounding. Income taxes are owed on the earnings withdrawn from the fixed index annuity each year.

Compounding Interest

Some annuities pay simple interest during an index term. That means index-linked interest is added to your original premium amount but does not compound during the term. Others pay compound interest during a term, which means that index-linked interest has already been credited also earns interest in the future. In either case, however, the interest earned in one term is usually compounded in the next.

You need to know whether your annuity pays compound or simple interest during a term. While you may earn less from an annuity that pays simple interest, it may have other features you want, such as a higher participation rate.

Cheaper Than Variable Annuities

Expect to pay anywhere from 0% to 1.5% of the Account Value in fees annually with a fixed index annuity.

Lock-In Your Gains

Every time you earn interest on any given anniversary, you lock in the gains you’ve received. Those gains can not be lost due to a downturn in market volatility like a variable annuity. You can never go backward in contract value outside a withdrawal, surrender charge, or fee. This method of earning interest is called The Annual Reset Method.

The Income Rider

The income rider distributes a flexible yet fixed retirement income stream that retirees can’t outlive. The income rider is also known as a Guaranteed Lifetime Withdrawal Benefit (GLWB). Use our annuity calculator to get a quote.

Accelerating Your Retirement Savings

Unlike 401(k)s and IRAs, indexed annuities have no contribution limits for non-qualified premiums. This may appeal to older consumers looking to boost retirement savings or those who have maxed out annual 401(k) and IRA contributions.

Longevity Protection

A fixed index annuity can include an income rider for an additional fee or free. The rider can be used to provide a source of guaranteed income that can last a lifetime.

Tax Advantages

Unlike withdrawals from 401(k)s and IRAs, which are fully taxable (except Roth IRAs), clients only pay taxes on the interest earned in their fixed indexed annuities for non-qualified premiums. Because the income is typically made up of a combination of interest earned and your original premium, only a portion of the income is taxable. This can help you use the annuity income in conjunction with fully taxable withdrawals from other retirement plans to lower your overall tax burden in retirement.

The Cons

Long Term Contracts

Fixed index annuity Contracts can range from 3 years in length to 16 years in length. However, the standard length tends to be a 10-year indexed annuity contract.

Limited Growth

Typically a fixed index annuity owner should earn better than a traditional fixed annuity but nowhere near a variable annuity. If you’re looking for all the upside potential in growth, check out a variable annuity.

How does a Fixed Index Annuity help a Pre-Retiree?

If you’re approaching the last step in your career, and you want to scale back in risk tolerance, a fixed index annuity might be a good way to grow your assets since you get to participate in a portion of the upside potential but protect from all the downside of a stock market downturn.

If you’re looking to convert your retirement savings into a pension income type of solution, there are many annuity products with guaranteed income riders that will tell you today what your annuity income payments would be in 5, 10, 15, or 20 years. This could be a good foundation for your fixed retirement income planning, especially if you want to meet goals for retirement.

Key Takeaway

Because fixed index annuities offer guaranteed income riders, a pre-retiree can create a retirement roadmap and solve for how much money needs to be saved going forward, starting today, to achieve their desired retirement income in the future, up to 30 years in advance.

How does an Indexed Annuity help a Retiree?

Who does not benefit from an Index Annuity?

  • A consumer seeking aggressive growth with all the upside.
  • An investor seeking short term commitments.
  • Someone wanting unlimited liquidity.

Fixed Annuity Vs. Fixed Index Annuity

How does an indexed annuity differ from a fixed annuity? A fixed index annuity is different from fixed annuities or MYGAs because of the way it credits interest to the annuity’s value. A fixed annuity only credits interest at a fixed rate. A fixed index annuity credits interest either by a fixed interest rate, the positive performance of an external index, or both.

Fixed index annuities credit interest using a formula based on changes in the index to which the annuity is linked. The formula decides how the additional interest, if any, is calculated and credited. How much additional interest you get and when you get it depends on the features of your particular annuity.

Your fixed index annuity, like other fixed annuities, also promises to pay a minimum interest rate. The rate that will be applied will not be less than this minimum guaranteed rate, even if the index-linked interest rate is lower. The value of your annuity also will not drop below a guaranteed minimum.

For example, many single premium contracts guarantee that the minimum value will never be less than 87.5% of the premium paid, plus at least 1-3% in annual interest (less any partial withdrawals).

The guaranteed value is the minimum amount available during a term for withdrawals and some annuitization and death benefits. In addition, the insurance company will adjust the value of the fixed index annuity at the end of each term to reflect any index increases.

Fixed Index Annuity Vs. Variable Annuity

The key difference between a fixed index and a variable annuity is the upside potential and the market volatility protection. The variable annuity’s strength is the ability to make 100% of the upside potential from a subaccount which is great. However, the variable annuity’s downfall is the ability to lose 100% of the money from market volatility, which is the fixed index annuity’s strength.

The variable annuity also does not offer an annual reset feature for accumulation like the fixed index annuity.

To put this in perspective, a variable annuity would need a return greater than both the loss and the fees combined to get back to the investment’s original value. For example, if the variable annuity had a 10% loss one year in addition to the 4% annual fee, the variable annuity would need a 14% return to break even and a 15% return to fully recover the following year.

Now imagine if the variable annuity’s losses continued to increase in a downturn, the time to recover would be even longer. When comparing a variable annuity with a fixed index annuity, compare the upside potential and the amount of time to recover from potential losses.

Fixed Index Annuities Vs. Mutual Funds

Mutual Funds

Mutual funds are investment products whose value fluctuates based on the underlying securities. When investing in an individual stock through a mutual fund, the value of your share is tied directly to the combined returns of all of the fund’s underlying securities. Thus, an investor fully participates in both the gains and losses of the investment. Share can be bought and sold daily, with some limitations.

Fixed Index Annuities

Fixed index annuities earn interest based on the upward performance of a stock market index but are not stock market investments nor participate in any investments. Gains are limited by a cap, spread, or participation rate. The interest earned is locked in each reset period. Thus, fixed index annuities protect from stock market loss. Index annuities are long-term savings products with limited liquidity.

Features and Definitions

Fixed Indexed Annuities have a diverse selection of features to offer both pre-retirees and retirees. The following describes fixed index annuity features that may be in your contract.

The Indexing Method.

The indexing method is the approach used to measure the amount of change in the index. Some of the most common indexing methods include point-to-point, averaging, declared fixed interest, all utilizing the annual reset method.

Locking In Your Gains.

The interest earned from a fixed index annuity is “locked-in” at the end of a reset period, and previous gains are protected from loss.

Any future decreases in the index will not affect the interest you have already earned up to that point in time. This means a down market does not impact your accounts, so you’ll never have to recover from negative returns.

Your fixed index annuity using the annual reset method may credit more interest than annuities using other methods when the index fluctuates up and down often during the term. This design is more likely than others to give you access to index-linked interest before the term ends.

Liquidity

The modern fixed index annuity contract typically offers several ways to access funds inside your retirement account despite popular belief.

  • Penalty-Free Withdrawals: The allotted amount or percentage of funds, an owner can withdraw each and every year.
  • Waiver of Premium: Some annuity companies offer a benefit that will waive surrender charges if you become disabled.

Death Benefits

Another misconception with fixed indexed annuities is there isn’t a death benefit to pass down to your loved ones, and the insurance company keeps your money. But, again, this is not true.

Except for the Life Annuity and Joint Survivor Annuity, beneficiaries typically will inherit the remainder of the contract in a lump sum. Another death benefit option is called the spousal continuation clause, which allows a spouse to continue the deceased’s contract for the remainder of the initial term.

The Income Rider and Living Benefits

Traditionally, annuities generate retirement through annuitization or systematic withdrawals. Systematic withdrawals provide the opportunity to run out of money, and annuitization offers zero flexibility. That said, fixed index annuities offer an optional income rider that can provide a steady income for a lifetime(s).

The income rider or Guaranteed Lifetime Withdrawal Benefit is an additional feature available with some annuities. Annuity owners can also see increases in their retirement income with an inflation-indexed annuity.

Annuitizing Contracts

Annuitize is the term referring to converting your funds into an irrevocable guaranteed stream of annuity income payments after a specified accumulation period. A deferred annuitization option is standard in all fixed deferred annuities but rarely exercised. Consumers use the income rider instead to generate lifetime income payments.

Check your annuity buyer’s guide or statement of understanding to find out the minimum accumulation period and payout period.

The Annual Reset Method

Annual Reset Method

The annuity’s index values are automatically reset at the end of each reset period. That means this year’s starting value becomes the next year’s starting value.

Any future decreases in the index will not affect the interest you have already earned up to that point in time. This means a down market does not impact your accounts, so you’ll never have to recover from negative returns.

Another annual reset advantage is interest can be earned as the market is recovering from a downturn.

Tradeoff’s

Some tradeoffs with annual reset might be that your fixed index annuity’s participation rate may change each year and will generally be lower than other indexing methods. Also, an annual reset design may use a cap or averaging to limit the total amount of interest you might earn each year.

Reset Periods

Reset periods are the points in your FIA or fixed contract that credits interest you’ve earned to your policy. Interest is locked in at the point and never goes backward from there. Reset periods can range from 1 year to a 5 year reset period.

Fixed Index Annuity Contract

Indexed Annuity Contract Values

  • Accumulation Value: Your Accumulation Value or Account Value is the current value your money is worth.
  • Minimum Guaranteed Value: The minimum guarantee value in fixed index annuities is the minimum amount your money is worth guaranteed at any given time.
  • Cash Surrender Value: The cash surrender value is the value your contract is worth if you cancel the contract before the surrender charge period has come to term.

Indexing Crediting Methods

Interest Crediting Methods are strategies you allocate in a fixed index annuity to earn interest over the contract. The indexing method is the approach used to measure the amount of change in the index. Some of the most common indexing methods, which are explained more fully later on, include annual reset (ratcheting), high-water mark, and point-to-point.

Point to Point

A point-to-point indexing method measures growth in an external index from one point in a given year to the same point of the following year(s). The index-linked interest, if any, is based on the difference between the index value at the end of the term and the index value at the start of the term.

Interest is added to your fixed index annuity at the end of the term. Since interest cannot be calculated before the end of the term, the use of this design may permit a higher participation rate than annuities using other designs.

The Trade-Off

Since interest is not credited until the end of the term, typically six or seven years, you may not be able to get the index-linked interest until the end of the term.

Annual Point to Point

This calculation method measures the change in index value using two points in time; the beginning index value and the ending index value for that year. Index-linked gains are calculated based on the difference between these two values.

The index change, if any, is then subject to an index cap rate, index margin, and/or participation rate. The annual interest credit will never be less than zero.

Two-year Point-to-Point

This calculation method measures the change in index value using two points in time; the beginning index value and the ending index value for that two-year term. Index-linked gains are calculated based on the difference between these two values.

The index growth, if any, is then subject to an index margin or participation rate. The interest credit will never be less than zero.

Monthly Point to Point

Also known as the monthly sum, this indexing method for determining any interest credit uses the monthly changes in the index value, subject to a monthly index cap rate. The interest credit is credited annually and is based on the sum of all the monthly percentage changes in the index value—which could be positive or negative.

On each contract anniversary, these monthly changes, each not to exceed the monthly index cap rate, are added together to determine the interest credit for that year. Thus, negative monthly returns have no downside limit and reduce the interest credit, but the interest credit will never be less than zero.

Averaging

In some annuities, the average of an index’s value is used rather than the actual value of the index on a specified date. The index averaging may occur at the beginning, the end, or throughout the entire term of the fixed index annuity.

Averaging at the beginning of a term protects you from buying your annuity at a high point, which would reduce the amount of interest you might earn. Averaging at the end of the term protects you against severe declines in the index and losing index-linked interest as a result. On the other hand, averaging may reduce the index-linked interest you earn when the index rises either near the start or at the end of the term.

Monthly Averaging

Monthly averaging is an indexing method where a snapshot of an index value on the same given day every month is averaged over a 12 month period.

Daily Averaging

This method for determining any interest credit uses a Daily Average calculation to determine a percentage gain or loss in the index value during your reset period. This is done by comparing the difference between the index value on the first day of the contract year and the Daily Average index value (usually 252 trading days), subject to an index margin. The interest credit will never be less than zero.

Declared Fixed Interest

Rate Premium allocated to the fixed account will be credited interest at a declared fixed account interest rate and is credited daily. The initial premium interest rate is guaranteed for the first contract year. For each subsequent contract year, we will declare, at our discretion, a fixed account interest rate that will apply to the amount allocated to the fixed account as of the beginning of that contract year. A declared fixed account Interest rate will never fall below the minimum guaranteed fixed account interest rate.

High-Water Mark

The index-linked interest, if any, is decided by looking at the index value at various points during the term, usually the anniversaries of the date you bought the fixed index annuity. The interest is based on the difference between the highest and index values at the start of the term. Interest is added to your annuity at the end of the term. Since interest is calculated using the highest value of the index on a contract anniversary during the term, this design may credit higher interest than some other designs if the index reaches a high point early or in the middle of the term, then drops off at the end of the term.

The Trade-Off

A trade-off might be that interest is not credited until the end of the term. For example, if you surrender your annuity before the end of the term in some fixed indexed annuities, you may not get index-linked interest for that term. You may receive index-linked interest based on the highest anniversary value to date and the annuity’s vesting schedule in other annuities. Also, contracts with this design may have a lower participation rate than annuities using other designs or may use a cap to limit the total amount of interest you might earn.

Low-Water Mark

In this crediting method, the index-linked interest, if any, is determined by looking at the index value at various points during the term, usually the anniversaries of the date you bought the fixed index annuity. The interest is based on the difference between the index value at the end of the term and the lowest index value. Thus, interest is added to your annuity at the end of the term. Since interest is calculated using the lowest value of the index before the end of the term, this design may credit higher interest than some other designs if the index reaches a low point early or in the middle of the term and then rises at the end of the term.

The Trade-Off

Interest is not credited until the end of the term. Therefore, with some annuities, if you surrender your annuity before the end of the term, you may not get index-linked interest for that term. In other annuities, you may receive index-linked interest based on comparing the lowest anniversary value to date with the index value at surrender and the annuity’s vesting schedule. Also, contracts with this design may have a lower participation rate than annuities using other designs or may use a cap to limit the total amount of interest you might earn.

Inverse Performance Trigger

The index value from the beginning of your contract year is compared to the index value at the end of the contract year. If the ending index value is equal to or less than the starting value, the money allocated to this option will be credited interest at the declared performance rate. If the ending index value is greater than the beginning index value, the money allocated to this option will receive a zero percent (0%) interest credit.

How Interest Credits is Determined

Now that you have an idea of earning interest with indexing strategies, you need to understand how the net interest is credited to your account. Since a major tradeoff with indexed annuities is participating in some (not all) of the upside, a measurement tool must dictate the portion that is credited to you.

Indexing Term

The index term is the period over which index-linked interest is calculated; the interest is credited to your fixed index annuity at the end of a term. Terms are generally from one to ten years, with six or seven years being most common. Some annuities offer single terms, while others offer multiple, consecutive terms. If your fixed index annuity has multiple terms, there will usually be a window at the end of each term, typically 30 days, during which you may withdraw your money without a penalty. For installment premium annuities, the payments of each premium may begin a new term for that premium.

Cap Rate

A cap is the ceiling an indexed annuity owner can earn in any given interest crediting method. Some annuities may put an upper limit, or cap, on the index-linked interest rate. This is the maximum rate of interest the annuity will earn.

Not all annuities have a cap rate.

While a cap limits the amount of interest you might earn each year, annuities with this feature may have other product features you want, such as annual interest crediting or the ability to take partial withdrawals. Also, annuities that have a cap may have a higher participation rate.

Participation Rates

Participation rates are the percentage of the upside an index annuity owner can participate in when selecting a crediting method. The participation rate decides how much of the increase in the index will be used to calculate index-linked interest.

For example, if the calculated change in the index is 9% and the participation rate is 70%, the index-linked interest rate for your annuity will be 6.3% (9% x 70% = 6.3%).

A company may set a different participation rate for newly issued annuities as often as each day. Therefore, the initial participation rate in your annuity will depend on when the company issues it. The company usually guarantees the participation rate for a specific period (from one year to the entire term). When that period is over, the company sets a new participation rate for the next period. Some annuities guarantee that the participation rate will never be set lower than a specified minimum or higher than a specified maximum.

The participation rate may vary greatly from one fixed index annuity to another and from time to time within a particular annuity. Therefore, you need to know how your annuity’s participation rate works with the indexing method.

Other features may offset a high participation rate, such as simple interest, averaging, or a point-to-point indexing method.

On the other hand, an insurance company may offset a lower participation rate by offering a feature such as an annual reset indexing method.

Renewal Rates

Renewal interest rates are what the caps and participation rates renew at every anniversary or reset period. Typically there is a floor an index-linked interest rate can renew at. For indexed contracts, renewals rates will apply to the caps, participation rates, spreads, fees, and the fixed interest amount that renews at every anniversary date or reset period.

Every type of deferred insurance contract (fixed and indexed) will have a minimum guaranteed rate, which is the “floor” the crediting rate will never fall below. This floor is established at the time of purchase and applies the life of the contract.

Some deferred contracts have a bailout rate as a special feature. Essentially this allows a contract to become 100% liquid if the renewal rate falls below a set rate. If your rate ever renews at or below the set bailout rate, you can withdraw all of your money without a penalty.

The Floor

The floor is the minimum index-linked interest rate you will earn. The most common floor is 0%. A 0% floor assures that even if the index decreases in value, the index-linked interest that you earn will be zero and not negative. As in the case of a cap, not all annuities have a stated floor on index-linked interest rates. However, in all cases, your fixed and fixed index annuity will have a minimum guaranteed value.

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Conclusion

When you receive your fixed index annuity contract, carefully read through and review it. Be sure every feature is what you understood your retirement plan would be. For example, there are disclosures, statements of understanding, or a prospectus to better understand what you have invested in.

If you find yourself worried or feel that you haven’t purchased what you understood, there is always a free look period which gives you a set number of days (usually 10 to 30 days) to change your mind about buying an annuity after you receive it. If you decide that you don’t want the annuity during the freelook period, you can return the contract.

Use a fixed index annuity calculator to get a better idea of your retirement income.

Shawn Plummer

CEO, The Annuity Expert

I’m a licensed financial professional focusing on annuities and insurance for more than a decade. My former role was training financial advisors, including for a Fortune Global 500 insurance company. I’ve been featured in Time Magazine, Yahoo! Finance, MSN, SmartAsset, Entrepreneur, Bloomberg, The Simple Dollar, U.S. News and World Report, and Women’s Health Magazine.

The Annuity Expert is an online insurance agency servicing consumers across the United States. My goal is to help you take the guesswork out of retirement planning or find the best insurance coverage at the cheapest rates for you. 

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