An annuity is a financial product that offers a steady income stream to individuals in retirement. However, many people may not be aware of the different features and benefits that annuities can provide, including the annual reset method. This guide explains the annual reset method in an annuity and how it can benefit retirees.
What is an annuity?
Before we dive into the annual reset method, it is essential to understand what an annuity is. An annuity is a contract between an individual and an insurance company, where the individual pays a lump sum or a series of payments. In exchange, the insurance company promises to provide a stream of payments (or a lump sum) back to the individual at a future date. Annuities are often used as a retirement income vehicle, as they can provide guaranteed income for life.
How does the annual reset method work?
The annual reset method works by “resetting” the annuity account value at the end of each year. This means any gains earned during the year are added to the account value, which is then “locked in” at the new, higher amount. If the market experiences a downturn the following year, the annuity account value will not decrease, and the gains earned in previous years will not be lost.
Advantages of the annual reset method
One of the advantages of the annual reset method is that it can provide retirees with a level of protection against market downturns. In addition, since the gains earned in previous years are “locked in,” retirees can feel more confident that their retirement income will not be negatively affected by market volatility.
Another advantage of the annual reset method is that it allows retirees to participate in market gains while providing some protection against market losses. This can particularly appeal to retirees seeking a balance between growth potential and downside protection.
Disadvantages of the annual reset method
One potential disadvantage of the annual reset method is that it may limit the growth potential of the annuity account. Since gains are “locked in” each year, the account may not be able to participate in market gains in subsequent years fully.
Another potential disadvantage of the annual reset method is that it may incur higher fees or surrender charges than other annuities. Therefore, retirees should carefully consider the fees associated with any annuity before making a purchase decision.
A Flight Of Stairs
A fixed index annuity owner earns interest based on the performance of an external index like the S&P 500. Insurance companies determine how much interest an owner earns through an annual reset.
- “Annual” refers to the time between two contract anniversary dates.
- Reset” refers to the annuity crediting and locking in the interest rate, then resetting for the next compounding period.
Think of an annual reset like a flight of stairs.
- Positive Years: Each time you earn interest, you create a new step in the flight of stairs.
- Negative Years: Every year, there is a negative return, you don’t earn a new step, and your account stays the same as the previous year.
Nothing happens if you earn zero or less interest in a reset period. Your annuity contract value stays the same. Thus, you do not lose money from the annuity due to negative stock market performance.
The annual reset method offers multiple reset periods that I’ll go over, which can be crucial to earning your interest throughout the annuity.
Annual Reset Point-To-Point Method
The index closing level after the first year of the index term serves as the index starting level for the second year’s calculation in the point-to-point method. The second year’s ending index closing level becomes the starting index closing level for the third year, and so on.
The reset credits interest to the index annuity’s account at the end of each year’s index term period. As a result, the accumulated interest compounds on an annual basis.
Multi-Year Reset
The annual reset strategy and the multi-year reset approach are identical, except that the multi-year reset method requires calculation periods at least two years long. In contrast, the annual reset technique uses a single year.
Annual Reset Method And Baseball
For fixed indexed annuities, I like to compare an annual reset interest crediting to baseball in which every reset period is a time “at-bat.” You can get a hit or strike out whenever you’re up to bat in baseball. The annual reset method works the same way. You can earn or not earn interest during each reset period in a deferred annuity.
Since multiple reset periods exist, you should be comfortable with how much chance you want to grow your account. The chance isn’t about how much money you will lose (because you can’t) but how much interest one could earn between periods.
Annual Reset
The annual reset is like it sounds: a reset period of 1 year. Every year you get an opportunity to earn or not earn interest. In a standard 10-year contract, you have ten opportunities to earn or not earn interest.
Two-Year Reset
A reset period of two years in length. Every two years, you can earn or not earn interest. For example, in a standard 10-year contract, you have five chances to earn or not earn interest.
Three-Year Reset
A reset period of three years in length. Every three years, you can earn or not earn interest. For example, in a standard 10-year annuity contract, you have three chances to earn or not earn interest (Year 9).
Five-Year Reset
A reset period of five years in length. Every five years, you can earn or not earn interest. For example, in a standard 10-year contract, you can earn or not earn interest.
Why Would Anyone Select A Reset Period Of More Than A Year?
Easy answer. More upside potential. The longer the reset periods, the more opportunity to earn higher interest. The tradeoff is the longer the reset period, the fewer opportunities to make up for a lost time, not earning interest.
Example
You open a 10-year indexed annuity contract.
You choose a 2-year reset period.
The first time you’ll see any earnings is on the first day of the 3rd year.
The two years go by, and you earn zero interest.
That stinks.
Now you have to wait until another two years to earn interest (or choose a shorter reset period), which is four years before you see any growth.
That’s a long time to see growth.
Yes, you protect your original principal, but who wants to wait long to see any growth?
The other side of that equation is that the earnings probably are more significant than an annual reset period if you earn interest.
Now imagine if you chose a reset period of longer than two years.
That’s where it gets dicey.
I like to say if you’re looking for consistency, stick with an annual reset.
Choose a multi-year reset strategy if you want maximum upside potential over the contract’s life.
The good news is you can mix and match strategies on most equity-indexed annuities.
You can always change your interest-earning strategy after each reset period. In addition, some annuity owners often elect a backup plan to guarantee their outcome, allowing them to empower their retirement.
If you’re lucky, the life insurance company offers a high minimum guarantee value to back you up in case of not earn anything.
Is the annual reset method right for you?
Whether or not the annual reset method suits you will depend on various factors, including your risk tolerance, investment goals, and financial situation. Therefore, retirees should work with a financial professional to evaluate their options and determine whether the annual reset method or another annuity product may suit their needs.
Next Steps
In summary, the annual reset method is a feature offered in some types of annuities, such as fixed index annuities, which can provide retirees with a level of protection against market downturns while also allowing them to participate in market gains. However, like any financial product, the annual reset method may not suit everyone, and retirees should carefully consider their options before purchasing. By working with a financial professional, retirees can evaluate their options and determine if the annual reset method or another annuity product may suit them.
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