Fixed Indexed Annuities- Am I invested in the Market?

Have you ever heard someone say… “My financial adviser has me in some sort of index, but they reassured me that I can never lose money even if the market goes down!” You might think to yourself: that sounds like a scam, and I’m glad that person is not my adviser. The truth? This product really does exist. You’re not actually invested in the market, and you can still participate in market gains. How is that possible? Because of the fixed indexed annuity.

So what is a fixed indexed annuity, and how does it work? Fixed indexed annuities are offered by insurance companies. Currently they are not classified as securities, because your principal is not invested in the market, and they can be sold by someone holding only an insurance license. If the principal were actually invested in the market, the product would be a security and only licensed financial advisers could sell it.

As with a plain fixed annuity, your money goes into the insurance company’s general account and you are guaranteed a rate of return. The difference is that you can tie part of that return to an index. You choose an index, and the insurer credits you a portion of the index’s annual return — but again, your money is not actually invested in the index or the market.

Let’s walk through an example to cement the idea. You have $100,000 to invest. You don’t want to be in the market, but you want a rate of return that beats your local bank’s 2% CD. Insurance Company A is offering: Fixed Annuity — 5 year — 3.90%
Fixed Indexed Annuity — 5 year — tracking the S&P 500, capped at 7% Which one should you choose, and what does each actually deliver? The fixed annuity pays 3.90% per year, tax-deferred, for 5 years — roughly $3,900 a year. Over the full 5 years that’s $19,500 in interest, for a total of $119,500 at the end. The $19,500 of interest is taxable as ordinary income when withdrawn.

The fixed indexed annuity, by contrast, credits you up to 7% per year based on the performance of the S&P 500. If the S&P returns 5%, you get 5%. If it returns 12%, you get 7% (the cap). If it returns 1%, you get 1%. So you can earn a higher rate than the fixed annuity — it depends on the index.

What happens if the market goes down? Suppose the S&P 500 returns -1.2% for the year. You don’t lose anything, because you aren’t actually in the market. You just don’t gain anything that year either. Your money remains in the insurance company’s general account. With fixed indexed annuities, there are several ways an insurer can credit your principal: cap rates, participation rates, point-to-point, 2-year point-to-point, and spreads. For this article we’ll focus on cap rates, as in the example above; the others will be covered in a future article.

One final, important point about fixed indexed annuities and crediting strategies. Suppose you buy a 5-year fixed indexed annuity with a 7% cap tied to the S&P 500. At the end of year one, the insurance company takes a snapshot of the index and credits your account with the S&P 500’s return. If the S&P returned 7%, your account is credited 7%, or $7,000. Your new balance is $107,000 — and that amount is locked in. It can never drop below that level.

In year two, the S&P returns 3%. Your account is credited 3% on the $107,000, bringing it to $110,210. Again, that balance is locked in. The process repeats each year until the contract expires. Fixed indexed annuities are an interesting way to participate in market upside without actually being in the market. In the example above, you could even split funds between a fixed annuity and a fixed indexed annuity to create a balanced approach: the fixed portion guarantees a base rate (say, 3.9%) in years when the index underperforms. This example is illustrative and simplified. As always, do your research, ask questions, and feel free to reach out to us at CFEFinances.com. Thanks for reading. Happy investing!