Discover the Exciting World of Fixed Indexed and Buffer Annuities! Is an index-based annuity the right choice for you?

Key Takeaways

• Discover the exciting world of index-based annuities, crafted to shield you from market downturns while offering fantastic growth potential!

• Experience the thrill of returns linked to stock market indexes with fixed indexed and registered index-linked annuities, without the need to own any underlying securities!

• Embrace the balance of security and opportunity, as insurance companies use caps, participation rates, and spreads to provide you with guarantees while managing your upside potential.

Wouldn't it be advantageous to invest in the stock market with its growth potential while simultaneously having protection against potential losses?

While stocks and bonds offer exposure to both gains and risks, certain annuities are designed with growth potential and risk mitigation in mind, albeit with important considerations. Two prevalent annuities in this category are fixed indexed annuities (FIAs) and registered index-linked annuities (RILAs), also known as buffer annuities. These are tax-deferred annuities that allow market participation while limiting downside risk.

These annuities can be complex, and the features that protect against market downturns may involve explicit or implicit costs and fees, depending on the product. This includes caps or participation rates that might limit potential gains. Often, a surrender charge is applicable if funds are withdrawn early.

Understanding Annuities

An annuity is a contractual agreement between an individual and an insurance company. Annuities are typically categorized into two main types: income annuities and tax-deferred annuities. Income annuities involve providing a lump sum upfront, after which the insurance company disburses income payments either immediately or at a future date specified by you. In contrast, tax-deferred annuities allow you to invest a portion of your savings, deferring taxes on any earnings until you begin withdrawals or start receiving regular income payments.

For individuals who have maximized their retirement accounts through regular contributions, tax-deferred annuities can serve as an additional savings strategy. Certain types, such as fixed indexed annuities (FIAs) and registered index-linked annuities (RILAs), offer protection against investment losses.

Differences Between FIAs, RILAs, and Other Annuities

Fixed indexed annuities (FIAs) and registered index-linked annuities (RILAs) are forms of tax-deferred annuities aimed at supporting long-term savings objectives. The returns of these annuities are linked to stock market indexes. While this may seem complex, it is similar to index funds, where returns are also linked to a market index. However, with these annuities, you do not own the underlying securities, and the issuer usually limits gains to provide protection against losses. (Further details will be discussed later.)

Understanding Fixed Indexed Annuities

A fixed indexed annuity is a deferred annuity that offers growth potential based on the performance of a market index, such as the S&P 500^® Index, while ensuring protection against negative returns from the same index. Additionally, they often provide a guaranteed level of lifetime income through optional riders.

Understanding Registered Index-Linked Annuities

Registered index-linked annuities also base their growth on the performance of a market index, allowing investors to benefit from some market gains. Similar to fixed indexed annuities, these products usually offer some protection against losses and cap the returns over a specified period. They may also include a guaranteed level of lifetime income through optional riders. However, a notable distinction is that RILAs generally offer greater market participation than fixed indexed annuities, albeit with reduced protection against losses.

Registered vs. Unregistered Index-Based Annuities

Both Fixed Indexed Annuities (FIAs) and Registered Index-Linked Annuities (RILAs) are regulated by state insurance authorities. However, RILAs are also registered with the federal Securities and Exchange Commission (SEC), whereas FIAs are not.

This distinction is significant because individuals selling RILAs must be registered and have passed the Series 6 or Series 7 examinations. Those who pass these exams are qualified to sell mutual funds and, if also licensed by the state for insurance, registered annuities such as RILAs and variable annuities. These products can be more complex and may expose you to greater market risk.

For instance, a registered index-linked annuity might offer a feature known as a buffer, which covers losses up to a specified limit. Beyond that limit, you may incur losses to your principal. In contrast, FIAs are designed to protect your principal, typically offering a floor, which serves as an absolute limit against losses. Note: You can lose principal in a fixed indexed annuity due to surrender charges if you withdraw assets before the surrender period concludes.

If you are considering purchasing one of these annuities, it is advisable to consider whether it is a registered or unregistered product. If the annuity is unregistered, your sales representative may discuss complex indexes but might not be licensed to sell securities, such as mutual funds.

Understanding Annuity Purchases Linked to Index Performance

When you invest in a Fixed Index Annuity (FIA) or a Registered Index-Linked Annuity (RILA), your returns are tied to an index selected at the time of contract purchase. Commonly available indexes include the S&P 500 for large-cap companies, the Russell 2000 for small-cap companies, the technology-focused Nasdaq, and the MSCI EAFE, which represents the international developed markets index. Some options even feature customized indexes from major financial institutions.  

Unlike an index fund, you do not own the underlying securities of the index. Your returns are linked to the index, meaning you are unlikely to fully benefit from the index's performance. For instance, returns from FIAs and RILAs typically exclude dividends, which are a significant component of equity returns over time.

These annuities generally calculate your return from the index based on a participation rate and/or a cap, which means you receive a percentage of the return and are subject to a limit, respectively, rather than obtaining the full return. Additional restrictions on your return may also apply, as specified in the annuity contract.

The following chart illustrates this, showing how over the past 20 years, ending December 2024, the S&P 500 Index has gained 8.22% annually without dividends and 10.35% with dividends.

How Dividends Might Affect Your Stock Returns

The chart shows what a $10,000 investment in the S&P 500 might look like by December 2024. This is just an example for demonstration purposes and doesn't represent any real investment performance. When thinking about investing, keep your current and future plans in mind, as this example might not fit them. Remember, the return rate used here isn't guaranteed. You can't invest directly in an index. The final values don't take into account taxes, fees, or inflation. Also, investments that have the potential for the returns mentioned come with the risk of losing money.

Below are some common features and terminology associated with FIAs and RILAs.

• Cap. Many annuities impose a cap on returns. For instance, if the index yields a 10% return but the annuity has a 5% cap, your account will receive a maximum return of 5%.

• Participation rate. This is the percentage of the index's return that the insurance company credits to the annuity over a specified period. For example, if the index increases by 8% and the annuity's participation rate is 80%, a 6.4% return (80% of the gain) would be credited. Many annuities with a participation rate also have a cap, which in this scenario would limit the credited return to 5% instead of 6.4%.

• Bonus. A percentage of the first-year premiums received is added to the contract value. Typically, the bonus amount and any earnings on the bonus are subject to a vesting schedule that may extend beyond the surrender charge period. Due to the typical vesting schedule, the bonus may be entirely forfeited if surrendered in the initial contract years.

• Spread. A fixed percentage is subtracted from positive index returns. If the index return exceeds the spread, the contract earns the net return (i.e., index return minus the spread). If the index return is less than or equal to the spread, the credited interest may be zero or negative, depending on the product's downside protection features (such as buffers or floors). For example, if the spread is 3% and the index returns 8%, the credited interest would be 5% (8% minus 3%).

• Buffers and floors. A buffer protects against market losses up to a specified percentage. A floor sets an absolute limit on losses, also specified as a percentage. Note: While other options exist to protect against or limit losses, these are the most common.

• Length of the guarantee. Elements such as caps and participation rates may renew on a schedule. Some products reset participation rates and caps annually, while others maintain the same rates for several years.

• Riders. These are additional features, such as minimum guaranteed lifetime income, that can be added to the annuity for extra costs, which may further reduce the return credited to the account.

It is crucial to understand that the performance of the annuity largely depends on the combination of features mentioned above and the index you select. Consequently, the performance of FIAs and RILAs can be complex to calculate and even more challenging to compare.

Understanding the Functionality of a Buffer Annuity

Consider an annuity with a 10% buffer. If the associated index declines by 10%, the insurer covers this loss, resulting in no change to your return. However, if the index decreases by 25%, the insurer absorbs the initial 10%, leaving you with a 15% loss.   

For illustrative purposes only.      

By definition, bear market losses surpass the protection typically provided by a standard buffer annuity, which offers coverage for the initial 10% of loss. (Bear markets are generally characterized by a decline in prices of 20% or more from a recent peak). During the Great Recession of 2007–2009, the S&P 500 experienced a loss of approximately 50% of its value. Although a 10% buffer may mitigate some of the impact of market losses, it will not offer complete protection.   

Alternatives to Indexed Annuities

FIAs and RILAs are not the sole choices for investors aiming for growth while minimizing losses. A diversified portfolio of stocks, bonds, and funds can achieve similar objectives with potentially fewer growth limitations.

• Professionally managed portfolios, such as those offered through a defensive portfolio advisory service, effectively mitigate the impact of market volatility.³

• A defensive portfolio strategically includes conservative stock investments, high-quality bonds, and alternative investments that are less correlated with traditional asset classes.

  Investing defensively allows you to adopt an approach that potentially results in shallower declines during broader market downturns. It's advisable to work with a professional who can dedicate time and expertise to maintaining a defensive portfolio, ensuring your plan stays on track.

There are additional annuity solutions that offer growth with protection.

• A variable annuity with a guaranteed minimum accumulation benefit (GMAB) rider provides a safeguard against losses.

  For a fee, the GMAB rider ensures that at the end of a defined holding period—typically 10 years—you'll retain at least the asset value you began with, assuming no withdrawals. Most GMAB riders also allow you to reset the level of principal protection annually if your investments have appreciated, restarting the defined period.

• If securing a guaranteed income stream is crucial, consider variable annuities with a guaranteed lifetime withdrawal benefit (GLWB) rider.

  This strategy combines growth potential with the ability to secure future retirement income today, shielding it from potential market downturns. It also protects your retirement savings from market volatility, inflation, and the risk of outliving your savings. The primary challenges are the variable annuity's costs and limited equity participation, making it a straightforward alternative to evaluate.

• Another option is the anchor strategy, which uses a fixed, predictable asset like a certificate of deposit (CD) or single-premium deferred annuity (SPDA) to protect part of your principal while pursuing growth with an equity component.

How to Decide if a Fixed Indexed Annuity or Registered Index-Linked Annuity is Right for You

When evaluating indexed annuities, consider their potential performance across various past market conditions. Balancing risk and reward requires a comprehensive understanding of your investment options and their potential outcomes in different market scenarios. To invest wisely, it's essential to understand these products, how they function, and assess their trade-offs.

Best Regards,

Stock Market Charlie