Fixed Indexed Annuities in Your Retirement Portfolio

March 27, 2023
Fixed indexed annuities can offer those in or near retirement a balance of security and potential growth. Let's explore what they are and how they work.

Your retirement may be decades away or starting in a matter of months. But at some point, you'll have to cross the retirement red zone—that final seven to 10 years before you stop working.

This period can be a bit tricky for some investors. You may still need to grow your portfolio, which generally entails taking market risk, while at the same time preserve capital, which involves reducing market risk. It's a dilemma—taking and avoiding risk simultaneously. And while some investors may think "growth" and "capital preservation" are contradictions, combining them is possible if you know where to look. Consider a fixed indexed annuity.

How a fixed indexed annuity works

Enjoying the benefits of potential market gains while protecting against loss might be difficult, if not impossible, with traditional assets like stocks and bonds. But a fixed indexed annuity—which offers a unique combination of insurance and investment features—might help you pursue both, assuming you can accept limiting your upside potential in exchange for downside protection.

An annuity is a contract between an investor and an insurance company that can accumulate money tax-deferred, provide a guaranteed income stream, or both. You buy an annuity with a single payment at the time of purchase or over time with multiple payments, within a predetermined window and subject to certain minimum and maximum amounts based on the annuity contract being purchased. After a predetermined period, called a "surrender charge period" (typically between five and seven years or possibly longer, depending on the annuity), you can withdraw your money without incurring surrender charges (charges imposed by the insurance company for early withdrawal), begin receiving regular income, or remain invested.

Fixed indexed annuities provide the potential to earn an attractive, tax-deferred rate of return—generally tied to the performance of a market index (e.g., the S&P 500)—and full protection of the contract value from market loss. Fixed indexed annuities offer the opportunity to capture positive index returns up to a limit ("cap rate"), while fully protecting against loss if the index return is negative.

Hedging the market's downside and upside

Say an investor bought a fixed indexed annuity with a cap rate of 5%. Here's what they could expect.

Limited upside: If the underlying index generates 10% in one year, the investor's upside gains would be limited to 5%. If the index returns only 4% in a given year, they earn the full 4% (because it's under their cap rate).

Limited downside: If the index generates a negative return, say –15%, the investor won't earn a return that year, but they won't take any losses either.

"Insuring" what other investments can't: If the investor invests directly in the market via stocks, ETFs, or mutual funds, there's no guarantee they'll be protected from loss. A fixed indexed annuity, however, is an insurance product, with certain, specified guarantees backed by the claims paying ability of the issuing insurance company, so it can protect their investment in a way other financial products can't.

Using a fixed indexed annuity as part of a retirement income strategy

Investors can choose to convert the money accumulated in their fixed indexed annuity into irrevocable guaranteed lifetime income. Alternatively, for an additional cost, many fixed indexed annuities offer an optional guaranteed lifetime withdrawal benefit that can be used to provide flexible guaranteed income for life, with a level of guaranteed growth each year withdrawals are deferred (up to 10 years). One retirement strategy involves using guaranteed income from a fixed indexed annuity to compliment other sources of income (e.g., social security) and cover part or all of the investor's expenses in retirement. This can provide some protection from stock volatility and risks associated with other types of investments and, in some cases, allow investors to spend more in retirement. Because the guarantees of an annuity are backed by the issuing insurance company, it's important to evaluate the financial strength and stability of the insurance company backing the annuity.

What else do I need to know about fixed indexed annuities?

A fixed indexed annuity may have withdrawal or surrender charges (a charge on an early withdrawal or the cancelation of the policy), and some contracts may also impose a market value adjustment.

Generally, any withdrawals in a given year during the surrender charge period (e.g., five or seven years) that exceed 10% of your account value will be subject to withdrawal charges and/or a market value adjustment.

While returns are generally based on the change in a market index (e.g., the S&P 500), money in a fixed indexed annuity is not invested directly in the market and does not receive dividends.

Withdrawals from a fixed indexed annuity will reduce its value and can be subject to ordinary income tax. If you take withdrawals before age 59½, you may also be subject to a 10% federal tax penalty. The decision to purchase an annuity within a qualified plan or IRA should not be based on the annuity’s tax-deferred accrual feature as this is already provided by the qualified plan or IRA itself.

Annuities are long-term investments rather than short-term vehicles, such as money market funds, bonds, and cash that are typically used to hold money for an emergency or other short-term purposes.

Using annuities to ride out the retirement red zone

As you approach retirement, you may be looking to reduce your equity exposure and risk of loss. At the same time, you may also want to continue seeking growth to increase the value of your investments and future cash flow.

Rebalancing your stock and bond allocations might help you pursue this sweet spot in your portfolio. Alternatively, a fixed indexed annuity is designed to offer this type of balance between security and potential growth. It may be worth considering as a potential addition to your portfolio.

Investors should carefully consider an annuity's risks, charges, limitations, and expenses. Fixed indexed annuity products are complex insurance vehicles. Please reference the applicable contract for other important information.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Annuity guarantees are subject to the financial strength and claims-paying ability of the issuing insurance company.

Please consider surrender charges that may apply upon terminating an annuity contract.

Please note that annuity withdrawals are taxed as current income, not capital gains. This may or may not be beneficial, depending on your tax bracket. Please consult a tax or accounting professional.

Withdrawals are subject to ordinary income tax and prior to age 59 1/2 may be subject to a 10% federal tax penalty.

The decision to purchase an annuity within a qualified plan or IRA should not be based on the annuity's tax-deferred accrual feature as this is already provided qualified plan or IRA itself.

The information provided here is for general informational purposes only and is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner, or investment manager.