Every day, 12,000 baby boomers in the United States reach the age of 65, according to the Census Bureau. By 2030, all baby boomers will be 65 or older.
One consequence of this demographic trend is that the investment objective of baby boomers has shifted from a desire for growth to a need for protection. It’s not surprising, then, that annuities that offer downside protection and guaranteed returns have become more popular than those offering high growth potential.
[Sign up for stock news with our Invested newsletter.]
We can see this in the annuity sales data provided by Limra, a trade association of financial services providers.
In 2023, the U.S. annuity market had record-high sales of $385 billion, driven by interest rate hikes and the popularity of annuity products with downside protection. This second factor is proven by the fact that fixed annuities and fixed index annuities made up 67% of these sales, while variable annuities were only responsible for 15%.
This is a dramatic change from 2013 figures, when fixed annuities and fixed index annuities were only 30% of annuity sales and variable annuities were 62%.
The following will consider what fixed index annuities are, why they align with baby boomers’ desire for downside protection, and whether you should include them in your retirement income plan:
— What is a fixed index annuity?
— How a fixed index annuity is administered.
— How fixed index annuities differ from other popular annuities.
— Why fixed index annuities are becoming more popular.
— Pros and cons of fixed index annuities.
What Is a Fixed Index Annuity?
An annuity is a contract between you and an insurance company to cover specific goals, but the key to understanding this particular annuity product is the word “index.” You will recall that an index fund, unlike an actively managed mutual fund, tracks the performance of a market index instead of trying to outperform it.
Similarly, a fixed index annuity, also known as indexed annuity or equity-indexed annuity, offers payment or returns based on the performance of a market index (the S&P 500, for example). While some fixed index annuities track a single index, others track multiple indexes.
More importantly, a fixed index annuity is designed to protect annuitants from market downturns by guaranteeing that their capital will be preserved regardless of stock market performance. While the return is based on the performance of a market index, the money is not exposed to the stock market directly. Rather, annuitants receive an interest credit based on the index’s annual performance.
However, this protection comes at a cost: Your returns might be limited. That is, if the tracked market index returns 9%, your account might only grow by 7%, for example. In essence, while there is downside protection, there is also an upside limitation.
A fixed index annuity contract is a tax-deferred account, and you can set it up with a lump-sum deposit, multiple deposits or a qualified transfer from a retirement account.
How a Fixed Index Annuity Is Administered
There are various features that insurance companies use to provide both downside protection and upside limitation that are at the heart of indexed annuities.
Below are popular upside limitation features:
Participation Rate
The participation rate is the portion of the index return that an annuitant will share. For example, if an insurance company offers an 80% participation rate and the annual return of the index is 10%, then the annuitant’s account will grow by only 8%.
The participation rate may also vary over the lifetime of the annuity contract.
Rate Cap
Some annuity providers will set a fixed rate of return that will be credited to the annuitant, irrespective of the actual return of the index. For example, if the rate is 10%, then that’s what you get even when the index returns 15% in a particular year.
Rate caps also change over the lifetime of the contract.
Fee
Alternatively, the annuity provider can set a fixed fee (say, 4%) and then deduct it from the return of the index. In this case, your return varies since the fee is fixed. However, the fees can also be changed.
For downside protection, the following features are used:
Adjusted Value
Most annuity providers will regularly adjust the minimum value of your account to reflect the returns you have earned.
Here, the minimum value is the lowest amount that can be in your account. In the beginning, it is the principal investment amount.
Minimum Return
The insurer may offer a guarantee to pay a particular interest rate regardless of the performance of the index. In this case, even when the index’s return is negative, you will earn the minimum return.
Loss Flooring
Some insurers set the highest amount of loss you can experience on the account to 0%. So, when the index’s return is negative, you won’t earn anything, but you also won’t lose anything. Said differently, you will break even.
Withdrawals
The first thing to note here is that a fixed index annuity is structured as a long-term contract. Consequently, it has a surrender period of five to seven years. If you choose to withdraw from it within this period, you will pay surrender charges or fees (the charges are lower the closer you get to the seventh year of the contract).
Second, instead of a lump sum withdrawal (liquidation), you can turn your fixed index annuity account into a guaranteed stream of income for a defined period, usually during retirement years. If you wait until after the surrender period, you can do this without paying any fee.
There is even a GLWB (guaranteed lifetime withdrawal benefit) rider that will pay you guaranteed income until death. This latter option is a good way to protect yourself against longevity risk — the risk of exhausting your retirement savings before death.
Third, note that a fixed index annuity is a tax-deferred account. You can fund your contract with either qualified or non-qualified dollars. Withdrawals will be taxed at the ordinary income tax rate. If you are making withdrawals prior to age 59½, you will incur a 10% early withdrawal penalty.
How Fixed Index Annuities Differ From Other Popular Annuities
Fixed Index Annuities vs. Fixed Annuities
A fixed annuity locks in a particular interest rate for each year of the contract. Thus, you can know with certainty what you will earn every year. Fixed annuities can give this guarantee because they do not invest in the stock market, and so their returns are not subject to the vagaries of the market.
The downside to this is that in the long run, fixed annuities offer lower returns than fixed index annuities. Because they are based on changes to a benchmark index, fixed index annuities tend to offer a higher rate of return even after any of the upside limitation features have been applied.
Fixed Index Annuities vs. Variable Annuities
Variable annuities have no upside limit or downside protection, and their performance is based on the fluctuations of the stock market.
While this is beneficial during a bull market, it is dangerous during a bear market. And this is why many baby boomers who are now approaching retirement age have been making the transition to annuities providing downside protection even if that means less returns.
Why Fixed Index Annuities Are Becoming More Popular
Downside protection for investors with a short time horizon (approaching retirement age) is the biggest benefit of fixed index annuities. And this is the fundamental reason why they are gaining popularity.
Similarly, the tendency to earn a higher return than fixed annuities is another attractive characteristic of fixed index annuities. Benefiting from market index performance when downside risk is already protected is great news for those seeking to maximize risk-adjusted returns.
This ties into investors’ pursuit of inflation protection. Since the growth of the stock market outpaces inflation over longer time horizons, having a contract that tracks the performance of a market index may offer greater inflation protection than investing in fixed-income securities.
Protection against longevity risk is another benefit of a fixed index annuity. You can convert it into a guaranteed stream of income for specified term or a lifetime.
With many retirees discovering that Social Security alone is inadequate to meet their basic needs, a fixed index annuity can provide another source of guaranteed income that will help them maintain their standard of living in retirement.
Pros and Cons of Fixed Index Annuities
Before deciding whether a fixed index annuity is right for you, consider four pros and cons of this contract:
Pros of Fixed Index Annuities
Downside protection. You can be confident that no economic downturn will cause you to lose money.
Tax-deferred growth. Money in a fixed index annuity account grows tax-deferred. It’s a good way to shift some tax burden to the future.
Credit based on market index performance. You can earn higher returns (even after upside limits) than with fixed annuities. Moreover, returns tend to be higher than the inflation rate.
Guaranteed income. You can turn your account into a stream of guaranteed income throughout your retirement years, or till death.
Cons of Fixed Index Annuities
Upside limits. Downside protection may come at the cost of a rate cap, limited participation rate or fees.
Uncertainty. Unlike fixed annuities, you can’t be sure of the return you will earn from year to year. It all depends on the upside limit method chosen. Even with a chosen method, the insurer can adjust the criteria.
Surrender period. There is a surrender period of five to seven years, and withdrawals during this time will be penalized.
Should You Purchase a Fixed Index Annuity?
A fixed index annuity is a good choice if you want the risk protection of a fixed annuity but also an opportunity to earn a higher return.
However, you must be sure that you are willing to leave this account to grow without any withdrawal for the surrender period. If not, the surrender charges you will pay might erode any extra return the account provides compared with a fixed annuity.
If you believe your Social Security benefit and other savings won’t suffice during retirement, a fixed index annuity is also a good way to supplement your income. Similarly, it is a good way to minimize longevity risk.
Before making any decision for or against a fixed index annuity, have a conversation with your financial advisor and discuss your personal and financial situation to determine the best course of action.
More from U.S. News
How to Become a Financial Advisor
9 Best Small-Cap Stocks to Buy for 2024
Fixed Index Annuity: Why It’s Gaining Popularity Now originally appeared on usnews.com
Clarification 04/02/24: This article has been updated to clarify that fixed index annuities are not invested directly in the stock market, and to remove a reference to fees that do not apply to all such annuities universally.
