A fixed index annuity, or an FIA, is a financial product sold by an insurance agency. It allows interest to accumulate on a deposited amount in a tax-favored account while often being designed to provide a distributed income payment. It is an easy way to create income for oneself in a manner that is similar to a pension, but using one’s own saved money to do so.
The primary advantage of a fixed index annuity is that the earnings it is able to create grow on a tax-deferred basis. No income taxes are paid on the money until it is withdrawn from the annuity. Some may be able to purchase their FIA using rollover funds from a tax-qualified plan or from a lump-sum distribution from another retirement option without experiencing severe tax implications.
The primary disadvantage of a fixed index annuity is the cost of the initial investment. Many carriers have a minimum investment amount of $100,000 that is required to create the initial account. Ongoing premiums might also be part of the contract. For those who want to use the FIA for future income, the average monthly payment received from a $100,000 investment would be about $500. To receive a $1,000 per month, up to $250,000 may be required.
Here are some of the additional pros and cons of a fixed index annuity to think about before making the investment.
List of the Pros of a Fixed Index Annuity
1. Fixed index annuities offer guarantees.
A fixed index annuity offers high levels of financial safety when compared to other investment products. The earnings and the premium are contractually guaranteed by the issuing insurance company. Assets must be set aside, called reserves, to cover the potential claims that all policyholders may have. That means, aside from maintenance costs, the balance of the annuity is not subject to a loss of market value. If the assigned index goes down, the interest is simply 0%.
2. Most FIAs allow for multiple deposits over time.
The average fixed index annuity is setup to receive flexible premiums. This type of annuity allows for multiple deposits made into the account over time. There are single-premium FIAs on the market, however, which would only accept a one-time initial premium, so it is important to carefully read the contract of the annuity before agreeing to its structure to ensure you receive the right level of flexibility.
3. Most FIAs allow for a right to examine.
In the U.S., most states require insurance carriers to provide new investors with a provision that is called a “right to examine.” Think of it as a free trial period for the annuity. If you don’t like what you see after agreeing to the terms and conditions of the annuity, the right to examine allows for a full refund of the initial investment for any reason. Some states have a 10-day right to examine period, but there are some, such as Alabama, Florida, and Maryland that offer up to 30 days for their right to examine. The State of New York provides a 60-day right to examine period.
4. The average fixed index annuity earns a higher interest rate than comparable banking products.
Depending on the market index being tracked and the current state of the economy, it is possible for a fixed index annuity to outperform the interest rates that are offered on low-risk investment solutions, such as a savings account or certificate of deposit. That is why this option is often used to protect principal when there is a downturn being experienced in a credit market. FIAs do not lose account value like bonds or mutual funds either.
5. It is a way to save for retirement when other options have been maxed out.
Investors who have maximized their contributions to their 401k and their IRA (and pension, for some workers) still have the option to save in a tax-deferred way with a fixed index annuity. Contributions are permitted without limit to this type of investment, even though it is a tax-deferred product.
6. Many FIAs permit an early retirement without penalty.
Workers under the age of 60 that are expecting a large lump-sum distribution from a profit-sharing plan may find themselves stuck with a penalty of 10%-20%, depending upon their circumstances. Thanks to the structure of a fixed index annuity, these lump-sum payments can be rolled over into an annuity policy without showing taxable income on reported finances for the year. As part of the setup process, equal periodic payments can be distributed as an income rider from the policy while reducing potential tax liabilities.
7. Money isn’t lost on a down market.
Caps can be a big negative for fixed index annuities, but they are in place to provide certain guarantees. With a fixed index annuity, let’s say the tracked market goes down by 7%. Because of your contract, you don’t lose anything. That’s a net return of zero, even though the market went down. Growth might be limited, but it is done to balance out years where a loss may occur, no matter how steep the loss may be.
8. An FIA creates a diversification option.
Even for an investor who believes strongly in the markets, a fixed index annuity provides another layer of diversification that can protect an income. Although taking some money and locking it away for up to 10 years before touching it may not be the best option for everyone, an annuity with a guaranteed income rider could create some comfort during the retirement years. Some riders allow for lifetime income of certain levels, even if the entirety of the initial investment has already been withdrawn.
List of the Cons of a Fixed Index Annuity
1. Most fixed index annuities lock up your cash for an extended period.
Some FIAs have a surrender period that may be up to 15 years. Even good FIAs will lock up the initial investment for at least 5-7 years. You can always withdraw your money before then, but there will be a market adjustment to the final balance and a likely early withdrawal fee that must be paid to the insurance company. If there are profits from the annuity, the taxes would need to be paid on them as well.
2. Many FIAs end up paying a lower overall interest rate.
When compared to other investment options, fixed index annuities often pay a lower interest rate to the investor. In return, there is less risk and less volatility, but there is also less risk of real wealth growth. That makes an FIA a good option for those who are wanting to avoid risk almost entirely, but not a good option for those who are looking to build wealth through their investment portfolio.
3. Most fixed index annuities have caps on market performance.
Although some FIAs use a proprietary index, most use the S&P 500 as the tracking index for the annuity. Interest is paid on the balance in the annuity based on the performance of the index, but there’s usually a cap in place. Let’s say there’s a fixed index annuity with a 2.5% cap in place. The index goes up by 6.8%. The investor would receive the capped rate of 2.5% and the carrier would receive the rest.
4. Surrender charges can be massive.
Most FIAs allow for about 10% of the principal of the annuity to be withdrawn without a surrender charge. Anything larger than that, however, initiates this fee. On a 10-year FIA, the first four years of the policy may have a 10% surrender charge in place. Unlike a CD that removes the interest earned with an early withdrawal, an early withdrawal on an FIA would result in a 10% reduction of the investment and a loss of the interest. For a $200,000 FIA, that’s more than a $20,000 penalty.
5. Most FIAs do not provide inflation protection.
Inflation can destroy the potential of a fixed index annuity. Using the 3.5% cap as an example, let’s say that inflation for that year is at 4%. Because there are no protections for inflation, the actual value of the FIA is 0.5% less. People who live in regions where hyperinflation can be a threat may wish to look at other investment options before an FIA.
6. Most income riders do not increase once the distribution phase begins.
For this example, let’s say the fixed index annuity offers a 6% income rider. That increase will most likely be received during the accumulation component of the annuity. Once the distribution phase of the annuity begins, the same payment is made every year until the end of your life. That can be problematic for some seniors who have changing financial needs that involve long-term or full-time care.
These fixed index annuity pros and cons are just the beginning of the evaluation process. As with an investment option, there are risks that must be carefully considered. This option is not right for everyone. Examine your personal finances, evaluate all potential pros and cons, and then choose the policy contract that will best meet your short- and long-term needs.