Last week’s blog post introduced a type of investment that may not be familiar to many of you – indexed annuities. For those of you who missed it, an indexed annuity is basically a fixed annuity that offers a guaranteed interest rate for a set period of time. Two features of fixed annuities that have traditionally made them a preferred investment choice when compared to similar-duration CD’s are higher interest rates and tax-deferred growth.
Indexed annuities take it one step further. In addition to having the two aforementioned features, indexed annuities offer upside potential, i.e., a higher potential rate of return than traditional fixed annuities. While the higher rate of return isn’t guaranteed, there’s always a fixed rate of return that provides downside protection.
As such, indexed annuities fall in between fixed annuities and equity investments such as mutual funds and variable annuities on the risk tolerance scale. Unlike variable annuities, other than surrender charges for early termination that apply to all annuities, unless an income rider is added, there are no fees associated with indexed annuities.
How is upside potential provided by indexed annuities? Indexed annuities are a hybrid product, with returns directly tied to the performance of a stated stock index. Stock indexes measure the performance of a specified group of individual stocks. Some popular stock indexes include the S&P 500, Dow Jones Industrial Average, and NASDAQ, to name a few.
If you invest directly in an index, or any investment for that matter, the difference between the value of your investment and your original purchase amount equals your unrealized gain or loss on any given day. Unlike a direct investment in an index where you participate fully in all gains as well as all losses, there are two basic differences when you invest in an indexed annuity:
- If the index’s return is negative, no loss is posted to your account.
- If the index’s return is positive, only a portion of the return, often times subject to a cap, is credited to your account.
In other words, you won’t participate in losses, however, you also won’t fully participate in gains. In any given year, the floor for your return is a minimum rate of return that can vary between 1% and 3% and the ceiling is a portion of the gain in the index to which your indexed annuity is tied, both of which are defined in your contract. Depending upon the indexed annuity, the minimum rate of return may not be on the full premium paid into the policy.
If you don’t want exposure to losses, however, you’re unsatisfied with taxable CD rates and are instead seeking tax-deferred growth with an opportunity to increase your investment return by a portion of upside market returns, then you may want to consider diversifying into one or more indexed annuities. Stay tuned next week as we continue our series on this investment strategy.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.