Three approaches to deciphering a valuable but sometimes complex annuity product.
Fixed indexed annuities made up nearly 57% of total annuity sales in 2019, and they’re hot in 2020. But are they a good idea?
Because they offer a chance to get a good portion of the stock market’s gains while offering complete protection from loss, they’re appealing in a time of unprecedented uncertainty.
Indexed annuities credit interest based on the growth of a market index, such as the S&P 500 index. In up years, you’ll profit. In down years, you’ll lose nothing but won’t earn anything. Indexed annuities thus can be a great idea, especially for pre-retirees and retirees who want to save for the long term while limiting risk without precluding growth.
However, there are a lot of moving parts, with different crediting methodologies and caps. It can be difficult to compare and determine which one is best suited for you.
How they credit interest
In exchange for downside market protection, you’ll usually receive less than 100% of the index’s gains. How much you’ll get depends on the limiting factor(s) used.
A cap rate is the maximum rate of interest the annuity can earn during the index term. For instance, the annuity may stipulate a limit of 6% annually. If the index performance does not exceed the cap, you’ll get the full return.
A participation rate determines what percentage of the increase in the underlying market index will be used to calculate the interest credits during the index term. For instance, it may say you’ll get 60% of the index’s rise.
A spread rate or margin is the percentage that’s deducted from the change in the underlying index value to determine the net amount of index-linked interest credited to the annuity. For example, if the underlying index grew by 11% and the annuity has a spread/margin of 4%, you would net 7%.
Look through the lens of your goals
So, where do you begin? I recommend first clearly defining your needs and goals. Think of three primary goals to choose from:
Safely grow your long-term money. If this is your primary goal, you are looking for indexed annuities that have a good likelihood of performing well by crediting the most interest possible over time. You’ll be less concerned with guaranteed-income options and other bells and whistles. All extra features have a cost to the insurance company, which usually passes the cost onto the annuity owner in the form of reduced earnings potential. They can work against your goal of maximizing the growth of your money.
Besides choosing a simpler product, what can you do to increase the odds you’ll get the best long-term return? You can start by ranking indexed annuities by their current cap rates or participation rates, but that doesn’t provide a complete picture.
Another way to compare is to run back-testing based on historical index performance to try and get an idea of how a particular indexed annuity sub-account might perform in the future. Of course, past performance is not a guarantee of future performance, but it’s a good starting point.
Some annuity agents have proprietary software and tools to help consumers make these comparisons. However, most back-testing assumes that the current cap rates and participation rates remain unchanged for the entire test period. This is a bit deceptive because insurance companies can adjust cap and participation rates annually, and many do. Understanding a particular insurance company’s history on cap and participation rate adjustments can be helpful.
Guarantee future income. If this is your main goal, you are looking for an indexed annuity that has strong future income guarantees, typically via an income rider. You may be less concerned with account value growth as long as the maximum future income goal is achieved.
This is the easiest goal to research. Again, some agencies, such as AnnuityAdvantage, have proprietary tools to compare and rank all indexed annuity income riders for easy comparison.
But you should not make your decision based solely on the amount of guaranteed future income. Since you’ll be relying on the insurance company to provide income payments for your lifetime, you should also consider their financial strength.
What if two income riders produce the same income payments? Look at other factors to break the tie. Which underlying annuity has higher cap or participation rates? Which issuing company is financially stronger and better rated? Which annuity offers indexes that you like—is the S&P 500 the only choice, or are there other options? Which one has better liquidity provisions?
Get both reasonable growth potential and future income guarantees. With this balanced approach, you will probably not get the very best growth potential or the best future income guarantees. By comparing for the best combination of growth and income, you should be able to do well in both areas. This will let you take advantage of both growth potential and guaranteed income depending on how your needs develop in the future. This gives you the most flexibility.
A competent, trustworthy and ethical annuity agency can help you sort through the complexities of indexed annuities and make the best choice. If an agent starts to ramp up sales pressure, look elsewhere.
Annuity expert Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed and immediate income annuities. It provides a free quote comparison service. He launched the AnnuityAdvantage website in 1999 to help people looking for their best options in principal-protected annuities. He writes on retirement income and annuities regularly.
More information, including updated interest rates from dozens of insurers, is available at https://www.annuityadvantage.com or (800) 239-0356.