If you have been watching the market for the past month you know how tumultuous things have been. On August 10, 2015 the S&P 500 closed at 2,104.18. And by August 25, 2015 it closed 11.2% lower at 1,867.61.
As of writing this article (August 27, 2015) it has rebounded slightly, closing at 1,987.66.
All this volatility has reminded many retirees of the importance of protecting their retirement nest egg. Many are looking to the safety of fixed annuities, specifically fixed index annuities. Which raises a good question:
Are fixed index annuities safe from a market crash?
Let’s take a look at the facts.
What Do Fixed Index Annuities Do Well?
The first thing to understand about fixed index annuities is that they do some things better than other things.
Fixed index annuities are conservative financial products. They can be used to protect your principal. If the market goes down, the worst that can happen to the value of a fixed index annuity is that it has zero growth that year.
When the market index goes down a fixed index annuity will not go down in value. Your original principal is protected AND any credited interest is protected as well.
Because of this, fixed index annuities are known as conservative financial products. They do not put your money at risk in the market.
So, are fixed index annuities safe from a market crash?
So the first thing that fixed index annuities (also known as equity indexed annuities) do very well is Principal Protection.
If the market index goes down you don’t lose value on your annuity. You would simply have no interest credited to your account that year.
Not a bad trade-off for many retirees that are concerned about protecting their money from a stock market crash.
The second thing that fixed index annuities do very well is Guarantee Income.
Most fixed index annuities allow you to add an optional income rider to the account. This income rider will guarantee a specific income payout in the future.
Generally the way it works is, the longer you delay drawing income from the income rider, the higher a payout the annuity will give you.
The contractual guarantees under an income rider are not based on how the market index performs. And on some fixed index annuities if the market index does well, the income payout can be increased above the contractual guaranteed payout.
So the market could crash and still the income rider would provide the contractual guarantees of income.
What Do Fixed Index Annuities Do Poorly?
These benefits seem pretty awesome, and I agree that they are. But does this mean that everyone should run out and buy a fixed index annuity?
First, fixed index annuities will not give you full growth from the market index. They will typically limit the level of growth with things called cap rates (or participation rates or spreads).
If the cap rate on the fixed index annuity is 5% and the market index grow by 12%, the fixed index annuity is only credited 5% interest. Essentially it would miss out on the other 7% in growth.
That’s just the price you pay to not have any downside loss from a market crash. And for many retirees that is not a bad trade-off. Especially considering how protection of principal becomes more important as you approach retirement.
“Are you comfortable not getting all of the market’s returns, if that means you don’t have to worry about losing money when the market goes down? This may be a good arrangement for a portion of your portfolio.”
*FYI: There are a lot of agents / advisors out there that may over exaggerate the potential returns of a fixed index annuity. Don’t buy into the dream that they give you. These are conservative financial products. Don’t expect high growth rates from a product that gives you full downside protection from a market crash. You are smarter than that.
Secondly, fixed index annuities typically have surrender charges. These can last for 7 years, and depending on which contract you choose, could go beyond 10 years.
Surrender charges decrease your flexibility in retirement. If the surrender charge is too high, it’s probably best to just hold on to what you’ve got instead of pay the fee and switch to another product.
That’s not to say surrender charges are a deal breaker. Just understand them. And before you buy a fixed index annuity understand that you should be willing to hold it for the contract period.
Thirdly, fixed index annuities are often times advertised in such a way that leads consumers to believe they are guaranteed very high returns.
This is really no fault of the product itself. It’s more the fault of the financial system and the advisors that advertise these products.
The high guaranteed returns are applicable to the income riders. They are guaranteed to grow at a specific rate, say 8%. But the rate is meaningless. The only thing that matters is the dollar amount of income they guarantee in the future.
The crazy thing is this: Fixed index annuities do other things so well, I don’t understand why they are advertised under this false premise of high growth rates.
Do advisors really want to have that conversation, “Uh, yes, Mr. Retiree. The ad did appear to promise a high rate of return, but let me tell you what that really means.”
Count me out on that. Let’s just be honest up front about how these products work. They have some good benefits that can help people in retirement planning, like principal protection and income planning.
Who Should Buy A Fixed Index Annuity?
So it really comes down to using these products responsibly.
The answer to the title of this article is: Yes, a fixed index annuity is safe from a market crash.
So if protecting your principal is important to you, then you may want to consider a fixed index annuity for a portion of your portfolio. This portion of your portfolio would be for conservative growth with no market risk.
They offer an alternative to investing in conservative bonds. And with bond rates low right now, bond values could decrease if rates start to creep up. You don’t have to worry about that with a fixed index annuity.
And if you want income guarantees for future dates, a fixed index annuity can give you those regardless of a market crash. You can get these guarantees by attaching an optional income rider to the contract.
You can’t get these guarantees from the market. Sure, you have better growth potential. And it’s probably a good idea to have some exposure to the market with a balanced portfolio.
But it may also be good for you to have some guarantees in place for a portion of your portfolio.
And don’t put all your money into a fixed index annuity. You need some liquidity for emergencies and life in general. And fixed index annuities typically have surrender charges. That’s why you need some cash on hand you can access.
I hope this helps you understand how fixed index annuities can be used as part of a well thought out retirement plan. They are not a silver bullet that can fix all retirement issues. They should be used in conjunction with your other investments.
And not all fixed index annuities are created equal. That’s why when I work with clients I show them side-by-side comparisons of various annuities that could meet their needs. They can then easily see which one is right for them. Your financial advisor should do this too.
If you know anyone that is considering a fixed index annuity, please forward this article to them. We can reach more people together than I ever could alone.
And if you have any questions about annuities, you can get on my calendar by CLICKING HERE, and ask me. I’ll help point you in the right direction.
Best of luck!