A Way to Get Some Stock-Market Upside without Any Downside

With the stock market seeming to reach new highs almost daily, investors face a quandary. They want to profit if the market stays strong. But many, especially older Americans, also fear the market is due for a major correction sooner or later.

One financial product, the fixed indexed annuity, is immune to stock-market downturns while offering a share of the profits when the market goes up. Fixed indexed annuities now make up 57.6 percent of the fixed annuity market, based on recent sales, according to Beacon Research and the Insured Retirement Institute.

These are complex contracts with many pros and cons. In exchange for a guarantee you’ll never lose any principal, you’ll typically get only part of the market’s gains as an interest credit.

The product is suited for people who want principal protection but are willing to withstand some interest-rate uncertainty. You get an opportunity to earn more interest than you can get from a fixed-rate annuity or a bank CD, allowing you to shelter some of your money from market risk without locking in a lower interest rate.

A fixed indexed annuity is a type of deferred annuity you buy with a premium deposit. It credits interest based on the changes to a market index, such as the Dow Jones Industrial Average or S&P 500. Interest is credited when the index value increases, but when it falls, you lose nothing.

Your principal and all previously credited interest earnings are fully guaranteed, regardless of future years’ index performance.

Here are some key considerations.

Fixed indexed annuities are suited for investors with a longer time horizon. They’re not a good place to park short-term money.

People who can meet all but the most unusual liquidity needs from other accounts are good candidates. They have the best potential for higher interest earnings over time.

These products are more complex than traditional fixed-rate annuities or bank CDs. Because several different indexing methods may be available in one policy, with most companies offering annual reallocation windows, it takes some thought to select which method(s) to choose. Comparing products from different insurance companies takes analysis.

You won’t know the interest rate you’ll earn until the index or indexes have completed their measuring period. Usually, this is annually, but some annuities won’t credit earnings till the end of two or three years or more.

Account withdrawals during the policy year (before the index crediting date) will have no index gains for the policy year under most contracts.

If the minimum interest is zero, there may be years when you earn no interest.

How Much to Allocate?

How much should you consider putting in fixed indexed annuities? One way to decide is to ask yourself: How much of my funds am I willing to wait to regrow in case of a market decline before I want or need to access them?

If you need to withdraw interest earnings annually, I’d recommend plain fixed-rate investments for that portion of your assets. Beyond that, the right mix of fixed-rated, indexed and equity investments is determined by your risk tolerance.

Most fixed indexed annuities reset annually. When an equity investor experiences a market loss, or she must make up that loss in future years just to get back to even. The fixed indexed annuity owner typically starts the year with a clean slate and doesn’t have a deficit to make up.

You don’t pay any income taxes on earnings as long as you keep them in the annuity. With most contracts, you can withdraw up to 10 percent a year without penalty.

Here are some additional details on how fixed indexed annuities work.

Crediting Methods

The annual point-to-point method measures the percentage change in the underlying index value between at the beginning and the end of the annuity contract year. A multiyear point-to-point method uses two dates that are more than a year apart.

Monthly point-to-point measures the percentage change in the underlying index value monthly.

Monthly averaging or daily averaging methods are used in some annuities.

Upside Limits

In exchange for downside market protection, you’ll usually receive less than 100 percent 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 that the limit is 6 percent for an annual index term. If the index performance does not exceed the cap, you’ll get the full return — unless there’s also a participation rate.

The participation rate determines what percentage of the increase in the underlying market index will be used to calculate the index-linked interest credits during the index term. For instance, it may say you’ll get 60 percent of the increase.

A spread rate or margin is a 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.

Ken Nuss is CEO of AnnuityAdvantage. Based in Medford, Oregon, AnnuityAdvantage is a leading online provider of fixed-rate, fixed-indexed and immediate income annuities. Its team sorts through the array of annuity options to provide each client with product offerings custom tailored to their specific situation. Every annuity offered is filtered, screened and analyzed for client suitability. More information is available at https://www.annuityadvantage.com.