How Does an Indexed Annuity Differ From a Fixed-Rate Annuity?
Nearing retirement is an exciting time filled with new plans and possibilities. But before you decide on your vacation home, you need to figure out how you’re going to fund your golden years. With retirement comes freedom, but for most people, this also means a significant change in your income level. To thrive in retirement, it’s critical to manage your money wisely. For many individuals, one of the most effective and secure ways to do so is by including an annuity as part of their retirement strategy.
To take advantage of these financial products, you need to understand the key differences between different types of annuities. In this article, we’re examining the difference between an indexed annuity and a fixed-rate annuity. By learning more about the different types of annuities, you can be better prepared to choose the one that is right for you and your family.
Since 1999, AnnuityAdvantage has been a leading provider of fixed-rate, fixed-indexed and immediate income annuities. With a wide range of annuity products and friendly, experienced annuity agents, we can help you find the most suitable annuity product for your plans and financial goals. And, with our easy-to-use website, you can find and purchase your annuity from the comfort of your home.
What is an Annuity?
Before diving into the differences between indexed and fixed-rate annuities, let’s start with the basics. What exactly is an annuity? An annuity is an insurance contract that, depending on the type, can be used to grow your money, provide immediate income or guarantee future income. Annuities are offered by insurance companies, through licensed agents, and are regularly used as part of an ideal planning strategy for individuals nearing, or already in retirement. If you want a safe and secure retirement funding option that will protect your money over time, you should look into the various types of fixed annuities.
There are two primary phases for an annuity: the accumulation phase and the annuitization phase. The accumulation phase is the first step which covers the period of time when someone is actively funding their annuity. During this phase, the payouts have yet to begin and the annuitant pays either a lump sum premium deposit or a series of regular premium payments. As the money is put into the annuity, the annuity value grows on a tax-deferred basis over time. When the annuity progresses from the accumulation phase to the annuitization phase, the guaranteed income payments begin. It is important to note that a significant percentage of annuities are never annuitized and are simply used as an efficient tax-deferred accumulation vehicle.
How Does an Indexed Annuity Differ From a Fixed-Rate Annuity?
While these two annuity products may sound similar, they function quite differently. Knowing the difference between an indexed annuity and a fixed-rate annuity is an important early step when researching various annuity options. So, how exactly do these two types of annuities differ?
In many ways, it comes down to reasonable guaranteed rates versus potentially higher rates that are not guaranteed. A fixed-rate annuity provides you with a guaranteed interest rate on your initial premium deposit. An indexed annuity, on the other hand, offers the potential for higher interest rates that are determined by the performance of a specified market index, such as the Dow Jones Industrial Average or the S&P 500.
Let’s take a closer look at how each of these annuities work.
How Does a Fixed-Rate Annuity Work?
A fixed-rate annuity is generally seen as the simplest and most predictable option when it comes to annuities. A fixed-rate annuity provides you with a set interest rate on your money for a set period of time, typically between 2-10 years. This means that you can better forecast and plan out the annuity’s future value. If you’re looking for a principal guarantee and a guaranteed rate of interest, this could be the annuity product for you.
With a fixed-rate annuity, you know the guaranteed interest rate and the guarantee period before you even purchase the annuity. Based on the amount of money invested, the annuity provider will use the total protected premium deposit to calculate the income payment expected during the annuitization phase, assuming you elect that option or choose to retain the same policy to an advanced age. Some of the benefits of this type of annuity include a guaranteed interest rate, easier budgeting, simple contract provisions, choice of terms, and the ability to withdraw or move your money at the end of the initial guarantee period.
How Does an Indexed Annuity Work?
Compared to a fixed-rate annuity, indexed annuities offer the potential for higher interest rates, but less predictability. An indexed annuity offers a fluctuating interest rate based on the performance of an underlying market index, like the DJIA or S&P 500. Thus, if the market performs well, you stand to make even more money than with a fixed-rate annuity. If the market performs poorly, however, you will likely receive zero interest for that year, but your principal is guaranteed and always protected from any negative returns. This is why many people choose an indexed annuity versus simply speculating directly in the stock market, particularly when nearing retirement as principal preservation becomes even more important.
You need to be aware of the participation rates and the rate cap for your annuity when considering indexed annuities. The tradeoff for downside protection is that most indexed annuities limit your upside in some way. With indexed annuities, you generally will not experience the full return of the underlying index used to calculate your interest credit. The participation rate determines what percentage of the index’s total return you will receive. Thus, if your participation rate is 60% and the index returns 10% for the year, you’ll receive a 6% interest credit on your annuity. With a rate cap, your maximum annual interest rate is capped at a certain percentage. Some of the benefits of an indexed annuity include the potential for higher interest rates, stability with downside protection, and principal protection.
What Should I Know Before Purchasing an Annuity?
Fixed annuities are a safe and reliable accumulation vehicle and income planning tool, but that doesn’t mean they’re ideal for every individual’s financial situation. In most cases, annuities are designed for those entering or preparing for their retirement years. Annuities can offer a steady stream of income that is both safe and consistent, which can help you better manage your funds throughout your golden years. When used for accumulation, annuities are also helpful at minimizing the devaluing risk of inflation.
However, while there are many benefits to this type of financial product, there are certain things to be aware of before purchasing an annuity. It’s important to note that the premium deposited into an annuity is illiquid, which means that, at least for a period of time, it cannot easily be withdrawn or surrendered for cash. Thus, if you anticipate needing large sums of cash in the immediate future, you’ll need to plan for this. Additionally, there can be surrender penalties if you’re trying to withdraw your money early from an annuity, and the IRS will impose a 10% tax penalty on interest earnings withdrawn prior to the age of 59 1/2. If you think you’ll need your money sooner rather than later, there may be better investment options to consider. For these reasons, annuities may not be as appropriate for younger people’s financial plans.
Like any financial decision, it’s critical to understand the exact stipulations of your annuity contract. For example, if the individual purchasing the annuity passes away before all the funds have been dispensed, what are the death benefit provisions? For example, most, but not all annuities will have a death benefit included in the policy that will disperse any remaining funds penalty free to a surviving family member named as a beneficiary. Understanding these details and specifications is crucial. By working with an experienced and trusted annuity provider, who can get you access to the best annuity rates, you’ll find the annuity that is right for you.
Conclusion – How Does an Indexed Annuity Differ From a Fixed-Rate Annuity?
Purchasing an annuity can be an ideal way to protect your money, to grow your nest egg or provide a reliable stream of income during your retirement years. However, before purchasing an annuity, you want to be sure you’re choosing the product that best aligns with your goals and financial plans for the future. Your annuity agent can help you assess the key differences between annuity products, but it’s always wise to educate yourself first.
Indexed annuities and fixed-rate annuities are two of the most popular types of annuities. A fixed-rate annuity provides a set rate of interest for a set period of time, which makes it easier to plan for the future. An indexed annuity credits interest based on the performance of the market index it is aligned with, which leaves it open to more interest rate uncertainty—but also with the potential for more reward.
AnnuityAdvantage is one of the most trusted annuity providers in the country. Since 1999, we’ve been helping individuals find the right annuity products for their individual needs. Visit us online to review our selection of competitive annuity rates and quotes to find the right annuity product for your financial goals. Together, let’s ensure that your golden years are safe, secure, and truly golden.