What to Consider When Buying a Fixed Index Annuity?

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Written by Hersh Stern Updated Friday, March 15, 2024

Reporter Christine Benz of Morningstar describes the important factors consumers should consider before buying an fixed index annuity.

First, it's important to understand that a fixed index annuity is not a direct investment in equities or mutual funds. You're not given control over a portfolio of stocks and bonds. Rather, the annuity is an agreement between you, the owner of the policy, and the insurance company about how the performance of a benchmark stock index effects the dollar value of your annuity.

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Second, each year on your annuity’s anniversary date, the insurance company credits a certain percentage of the gain in your chosen index (usually S&P 500, Nasdaq, or DJIA Index). This percentage is determined by a “cap rate” or “participation rate.” For example, if your annuity has a cap rate of 4% and the S&P 500 Index rose 9%, then your account is only credited with a maximum 4% gain. On the flip side, if the S&P 500 Index drops 15% one year, your account will not suffer a loss. The equity index annuity will be credited a "gain" of 0% (or sometimes a minimum guaranteed rate for that year). In other words, because the insurance company puts a cap on your gains, they protect you against negative market performance, too.

The third aspect to consider is your time horizon. Many equity index annuities have lengthy “surrender charge” periods, even as long as 17 years. During this time, you cannot withdraw an amount from your account which is greater than the interest you earned (that year), without facing a substantial surrender fee or penalty (often as high as 15%-20%). Because of these restrictions, it makes sense to set aside sufficient funds outside of your equity annuity, for emergencies. Do not purchase a fixed index annuity if you are planning on accessing your principal before the end of the surrender fee period.

Lastly, you should always consider the financial strength of the insurance company issuing your index annuity. The most common annuity rating services are A.M. Best, Standard and Poor’s, Moody's and Fitch. The ratings for many of the fixed index issuing companies is here.

SOURCE: Morningstar MORE COVERAGE: Washington State Department of Financial Institutions

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