Learn How To Retire: Individual Empowerment

What is an index annuity? An index annuity is a fixed annuity offered by an insurance company. This index annuity earns a minimum rate of interest and offers the potential for excess interest based on the performance of an index. There are two major types of annuities in the world- fixed and variable. Variable annuities operate a lot like mutual funds in that most of the investment return (and risk) are passed to the investor. Fixed rate annuities operate more like an account at a bank paying a stated rate of interest. Fixed annuities pay a minimum guaranteed rate and the potential for more interest depending on the performance of an equity or bond index. Since interest is based on an index, isn’t this similar to a variable annuity? No, if a variable annuity account goes down, you could lose principal. Index annuity principal is protected from market risk – you can’t lose principal if the index declines. Variable annuity gains are not locked in. Once index-linked interest is credited in an index annuity it can not be lost, even if the index declines substantially. Variable annuities also include reinvested dividends but neither the index nor index annuities reflect reinvested dividends. So do I get all of the index gains and none of the losses? No. It costs the insurance company to provide this protection against loss. This means that you will not fully participate in all of the gains when the market goes up, but you also will not lose principal in a falling market. What kind of interest will I earn? Index annuities are designed to provide a return somewhere between stock market vehicles and savings instruments, or somewhere between mutual funds and CDs. Because interest is linked to movements of an index, there could be periods when the index annuity credits double digit interest rates, and years when zero is credited. Index annuities were created with the intention of providing a more realistic potential for higher interest rates than other instruments that protect principal from market risk. How could I earn zero? The primary goal of the minimum guarantee is to protect the principal from market risk. Many companies minimize the minimum guarantee so, if the market stayed down for years, the owner would only get back their money plus a few dollars interest. By minimizing the minimum, and only crediting the minimum guarantee at the end of the term, companies can let index annuities participate in more of the possible index performance. There are index annuities that credit at least a minimum interest rate every year, others that offer the thinnest possible minimum return to maximize participation in the index, and still others in between. How did the bear market affect index annuities? No index annuity owner lost any principal or credited interest due to the market decline. Do index annuities have fees? Yes. Not in the same way that a variable annuity or mutual fund does, but more similar to banking fees. Index annuities have penalties for early withdrawal if you surrender the annuity early. You need to match the period with your goals while keeping in mind that all annuities are designed to be long term savings instruments. If the index increases, you will not get all of the upside. This doesn’t mean that the insurance company gets the other part of the increase. After protecting the minimum guarantee and covering expenses, any remaining money is used to provide the index linked interest. What interest have index annuities actually credited? The highest index annuity interest rate credited for one year was over 40%., but during the millennium bear market most index annuities credited 0%. Index annuities have been around since 1995, and since then, we have seen the strongest bull market in years – with five years of high double digit stock market gains, and the worst bear market in three generations. Index annuities are designed to provide a return somewhere between stock market vehicles and savings instruments and they have been performing as intended. Are all index annuities the same? No. Index annuities have different penalties for early withdrawal, may offer different options for indices, and one index annuity probably credits interest at a different rate from another. Some index annuities credit interest each year, some wait until the end of a longer period, some average the index values, others set a cap or maximum on the interest that may be paid, and some guarantee all of the fees or moving parts will not change, while others have the flexibility to adjust. What this means is one company could offer 100% participation in their way of calculating interest, and still credit less interest than another company that participates in 60% of a different method. Or, a company with a 3% asset fee could pay more than another company quoting a 0% fee. Can I get back less money than I put into a Fixed-Indexed Annuity? Yes. If you cash in an index annuity before the term expires, surrender charges are usually deducted from the accumulated value which is the original premium plus any interest credited. If the charges are more than the accumulated value, you will get back less than you put into the annuity. Are Fixed-Indexed Annuities safe? Yes. Both principal and credited interest are protected from index declines, so the worst thing that could happen is the stock market drops for years, and you still get back your principal plus a little interest. The index annuity is as safe as the insurance company issuing it. States and independent rating firms examine financial books of insurance companies on a regular basis, and they make sure that there is enough money to cover everything, which is why you rarely hear of an insurance company going bust. If a company did go out of business, other insurance companies would assist with the annuity contracts of the troubled company. Also, every state has a guarantee fund to dip into and protect annuity contract owners, within certain limits. Who buys a Fixed-Index Annuity? People purchase an index annuity because they are not satisfied with the returns from their CDs and fixed rate annuities, and don’t have the time for the stock market. If you have sufficient time to recover from potential losses, direct stock market investments should give you a higher return than index annuities. However, if your timeframe is too short to recover from a potential bad market, or you simply don’t like the idea of possibly losing principal, index annuities are used as an alternative saving vehicle to bank instruments, fixed rate annuities, bonds and mutual funds. What are Fixed-Indexed Annuities? A Fixed-Indexed Annuity (FIA) is a fixed annuity with an interest rate that is linked to the performance of a stock index (S&P500 or NASDAQ for example). The interest rate can increase or decrease depending on the market, but is guaranteed by the issuer not to go below a specified rate. FIAs offer safety of principal, a guaranteed minimum return, and the ability to participate in market gains through and index-linked interest rate. FIAs have many features such as participation rates, interest rate caps, and administration fees which vary widely. There are also many methods used to calculate and credit interest such as the point to point, high-watermark, averaging, and annual reset indexing methods. Features and indexing method directly affect an FIA’s potential return. An FIA can be described as a hybrid of a fixed annuity and a variable annuity, having some characteristics of both, and falling in between regarding the potential for return and levels of risk. With a traditional fixed annuity, the annuity issuer guarantees both the rate of return and the payout. Investors in fixed annuities elect safety of principal and guaranteed returns over market risks and the potential for higher returns. With a variable annuity, the rate of return varies according to the performance of the investments you choose from those offered by the issuer. With the exception of a guaranteed sub account, variable annuities do not offer any guarantees on the performance of the sub-accounts. You assume all the risk related to those investments including the risk of losing principal. In return for assuming this greater amount of risk, investors in variable annuities have a greater potential for growth in earnings. FIAs take the middle ground, offering limited downside risk balanced by limited upside potential for returns. They offer safety of principal and, generally, a minimum rate of return if the FIA is held for the full term. How do FIAs work? As with fixed and variable annuities, an FIA is a contract between you and an insurance company, in which you pay premiums and the issuer promises to make periodic payments to you in the future. You can pay premiums in one lump-sum or in installments over time. What makes FIAs unique is that they offer a minimum guaranteed interest rate, but allow for the possibility of higher earnings by linking the interest rate calculation to the performance of an equity index. Interest is calculated using a formula based on changes in the index. The terms of the FIA contract dictate how interest is calculated and when it is calculated. What are some key FIA features? Term Term refers to the holding period or the period over which interest is calculated. Terms vary from one to seventeen years. Some FIAs credit interest only at the end of a term, while others may credit annually or periodically. Some FIAs pay simple interest while others pay compound interest. These features are important, not only because they affect the amount of your return, but also because having interest credited to your FIA periodically instead of at the end of the term increases the likelihood that you will receive at least some interest if you surrender your FIA before maturity. Participation rate The participation rate determines how much of the associated index’s gain will be used to calculate the interest rate. For example, if the participation rate is 90% and the index that the FIA tracks increases by 8%, the interest rate credited to the account would be 7.2% (8 x .9 = 7.2%). Participation rates vary, but 50% to 100% is typical depending on the index crediting method. Interest rate caps The interest rate cap, or cap rate, is the maximum rate of interest that the FIA can earn. If the participation rate is 100% and the index returns 10% with a cap rate of 7%, the interest credited to the account would be 7%. Administration or asset fees Some FIAs have an administration or asset fee, instead of, or in addition to the participation rate. The administration fee is a percentage that is subtracted from the index’s gain. For example, if the administration fee is 2% and the index has an increase of 8%, the interest rate credited would be 6% (8%-2%=6%). The administration fee is sometimes called the margin or spread which is subtracted only from the index gain you will never have a spread if the index is 0%. What are some different indexing methods? Point to point The point-to-point method compares the value of the index at the beginning of the term to its value at the annual anniversary or the end of the term, disregarding fluctuations in between the two points. Interest may not be credited to your annuity until the annual anniversary or the end of the term. This is the simplest method. High watermark The high watermark or look back method checks the index at specific points during the term, such as each anniversary date. The highest of these is then used as the end-of-term index level and compared with the index value at the beginning of the term. With this method, interest is added to the value of the annuity at the end of the term. Averaging The averaging method involves several points of the index to establish the beginning and/or ending index value. For example, the index’s value at the end of each month for 12 months may be added together and divided by 12. Averaging can protect you against sudden declines in the index, but may also reduce returns if the market rises rapidly. Annual reset This method compares the index from the beginning to the end of each year. Interest is added to the value of your annuity at the end of each year. Once credited to your annuity, the interest is locked in, and can never decline. The beginning index value is reset at the end of each year, so future decreases do not affect the interest already earned. With this method, last year’s ending point is the next year’s starting point. What are the key strengths of FIAs? ◦They offer safety of principal and generally guaranteed minimum returns. ◦They offer tax deferred growth. ◦They have no annual contribution limits as long as they are flexible premium FIAs. ◦There is a guaranteed death benefit for your beneficiaries. ◦There are no penalties for mandatory distributions at age 70 ½. ◦They give you the option of receiving a guaranteed income for life, called annuitization, or may offer a Guaranteed Minimum Income Benefit (GMIB) for life without having to annuitize. ◦They may avoid probate. ◦They allow for participation in market increase. What are the key tradeoffs? ◦Your participation in market increases is limited. ◦Feature variations can make choosing the right FIA challenging. ◦When withdrawn, earnings are taxed as ordinary income based on your tax bracket at the time of withdrawal. ◦Withdrawals made prior to age 59 ½ are generally subject to a 10% penalty unless certain circumstances apply. Fixed and Fixed-Indexed Annuities Which is best for you? An annuity can provide a means of accumulating interest on a tax-deferred basis, and also provide an estate instrument which preserves and protects assets. There are variable annuities and fixed annuities. When newspapers and magazines mention annuities, they are almost always talking about variable annuities. In a variable annuity, income or account value is based on the value of the stocks or bonds or mutual funds backing the annuity assets, so the income and account value may fluctuate. The investment risk in variable annuities is incurred by the annuity owner, unlike in fixed annuities. Variable annuities are therefore considered investment securities and can be a risky place to put your safe money. Fixed annuities provide a minimum guaranteed growth rate and are considered savings instruments. All fixed annuities are issued by insurance companies and are not government or bank obligations. What are some features of fixed annuities? People purchase Fixed-Index Annuities because they are attracted by the higher returns of the stock market, but they don’t like the idea of possibly losing principal in a stock market investment. An index annuity offers the potential to earn more interest than they might receive from bank instruments or fixed rate annuities, while protecting both principal and credited interest from stock market risk. Yield Fixed annuities guarantee a minimum interest rate and the potential for additional interest, and have often offered higher interest rates than other safe money vehicles. There are two basic methods used in crediting interest, fixed rate and index linked rate. Fixed rate Many fixed rate annuities declare a new interest rate each year; while others lock-in a rate from two to ten years. The minimum guaranteed interest rate would either be set at the time of the annuity’s purchase or float. What are the tax advantages? Money remaining inside an annuity grows without being taxed until withdrawn. Unlike Qualified retirement accounts where you must begin taking out money around age 70 ½, most annuity contracts permit the owner to enjoy the advantage of tax deferral until age 85, 90, or even later. Tax deferred does not mean tax free, interest is taxed when withdrawn. Also, the IRS charges a 10% penalty on interest, in addition to regular taxes, if withdrawals are made before age 59 ½. What is the liquidity of a fixed annuity? Fixed annuities offer a wide variety of term choices ranging from as short as a year to as long as twenty years. A fixed annuity may have a penalty for early withdrawal, although most permit the withdrawal of at least interest earned each year without penalty. The term and liquidity provisions should match your needs. Is the principal safe? Fixed annuities do not subject principal and credited interest to market risk. A fixed annuity is as safe as the insurance company issuing the annuity and insurance companies have an exceptional record of safety. If you have more questions about the information provided or about your retirement situation please contact your local <a href=”http://www.safemoneyrep.com”>Safe Money Representative</a>