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Financial Planning with Fixed-Index Annuities

Financial Planning with Fixed Indexed Annuities

Annuities are a complex and often misunderstood kind of insurance product. They’ve also been the subject of some negative press, partly because some contracts come with high costs and a fair amount of complexity.

However, annuities shouldn’t all be judged by the standards of the worst products. There is no single annuity product or type. Different annuities have different characteristics, attributes, terms, and uses.

Here, we’ll focus on using fixed indexed annuities (FIAs) to accumulate savings for retirement. (You can read about using FIAs to generate guaranteed income in retirement here.

Before getting into how they work it’s worth noting that FIAs might appeal most to investors with “conservative money” to invest. This could be a portion of their portfolios that they’d like to protect, while earning tax-deferred returns that can compare favorably with certificates of deposit (CDs) or Treasuries.

What follows should be considered an introductory sketch. When you buy an FIA, you’ll likely have to make a variety of decisions about how you accumulate returns, how long your contract will last and other factors. We would suggest contacting a Schwab annuity specialist for a more detailed explanation.  

FIA basics

Because you can use an FIA to accumulate tax-deferred savings for retirement, it might help to think of them as another tool you could include in your retirement-savings toolbox, alongside a 401(k) or individual retirement account (IRA). Contributions are often made with after-tax dollars, but you pay no taxes on the gains until start making withdrawals. At that point, gains are taxed as ordinary income (which could potentially include the 3.8% net investment income tax).

One area where FIAs differ, of course, is that they are insurance products, not investment accounts. When you buy one, you turn a lump of your savings over to an insurance company, rather than keep it invested in the market. In exchange, the insurance company guarantees that your original principal won’t fall in value (so long you as don’t make early withdrawals and depending on the financial strength and claims-paying ability of the insurer).

As noted above, FIAs typically offer potential returns above what you could earn from CDs or high quality bonds. The mechanism used to determine these returns makes FIAs unique—it can also seem a little complicated. FIA investors have the option of potentially boosting their returns by having their account track the performance of a particular stock index, such as the S&P 500® Index.

Tracking a stock index isn’t the same as actually being invested in the stock market. Rather, if an FIA’s selected stock index rises, then the rate of return on the FIA can also rise. (Though, gains are usually capped, as we’ll see below.) If the index falls, the investor won’t earn any interest, but the FIA protects the principal.

If you’re shopping for an FIA, understanding the formula behind the potential returns on offer is key. One criticism leveled against FIAs is that the formulas are complex. However, if you do your homework and talk with an annuities specialist, you can go a long way toward avoiding any surprises.

The following case studies don’t cover all the possible formulas, but they might give a sense of how they work for some investors. 

Case #1: Point-to-point cap rate accumulation

Depending on the contract, investors may be able to choose to have their interest accrue based on the annual change in a particular stock index. That means that if the index rises over the course of the year, the interest rate on the FIA might also rise—up to a point. Most FIAs cap the rate of return, so there are limits on the upside. In years when the index falls, the investors would earn nothing, but the principal would be protected. 

Consider the case of Lisa. She is 55 years old, plans to retire in 10 years and thinks of herself a conservative to moderate investor. She is looking to protect $100,000 in exchange for modest returns, but also wants to give her money an opportunity grow if the market rises. She elects to track the S&P 500 Index and have her returns accrue based on the annual change in the index.

Lisa buys an FIA on Dec. 31, 2006, and makes no early withdrawals. Her contract caps her rate of return at 5%.
The table below shows where she might have ended up.

Contract value is $138,740 at end of 2016.

As you can see, Lisa’s rate of return was either at or below the 5% cap rate in years when the S&P 500 rose. For example, when the index rose 3.53% in 2007, her interest rate was also 3.53%. When the index rose 23.45% in 2009, Lisa earned the 5% limit.

In years when the index fell, her principal held steady. Overall, her average annualized return would be about 3.3%—less than the 4.7% average annualized return she might have earned from an investment in the S&P 500—but she also wouldn’t have faced any losses during the financial crisis in 2008-2009.

Case #2: Point-to-point declared interest accumulation

Some—not all—FIAs also give investors the option of earning a fixed rate of return that is based not on how much a target index has risen, but on whether it rose at all. For some FIAs, this is known as a declared interest option. It works like this: In years when the targeted stock index rises or is flat, the FIA investor receives the declared fixed rate. In years when the index falls, the investor might receive nothing, but still enjoy principal protection. 
The table below shows how Lisa would fare had she opted to earn a declared interest rate of 4.60% rather than annual accumulation.

Contract value is $137,000 at the end of 2016.

As you can see, in years when the S&P Index rose, Lisa received the declared interest rate of 4.60%—even in 2007 when the S&P Index rose just 3.53%. In years when it fell, her principal held steady.  Overall, her average annualized return would be about 3.2%.

When FIAs might work 

Again, FIAs can be complex and might not make sense for every investor, especially those who are willing to take on more risk by staying invested in the market, or those not willing or able to spend the time to understand how they work.

In general, using an FIA for accumulation could work for investors who:

  • Have a lump sum to invest.
  • Have “conservative money” to invest.
  • Don’t want a portion of their money to be exposed to market risk.
  • Want to maintain access to their money, but understand they may be subject to surrender charges if they withdraw too much too soon.
  • Are willing to forgo some potential upside in an up market in exchange for the insurance features and other guarantees offered by an FIA.

Investors who are interested in including an FIA—or any other kind of annuity—in their retirement savings toolbox should talk with a Schwab annuity specialist. They should also compare FIA terms with those available from other kinds of annuities and investments. 

What you can do next

For more information on FIAs, please talk with a Schwab annuities specialist at 888-311-4889. You can also read about Pacific Life’s Pacific Index Choice FIA offered by Charles Schwab here.

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Important Disclosures

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.

All annuity guarantees are subject to the financial health and claim-paying ability of the issuing insurance company. Neither Schwab nor its affiliates provides insurance guarantees.

A guaranteed lifetime withdrawal benefit is an optional rider available for an additional charge. It is not a contract value, cannot be accessed like a cash value, and will not preserve your account value which will deplete with each withdrawal until it reaches zero, though payments under the terms of the rider will still continue for life. Withdrawals in excess of the specified annual payout amount will permanently reduce future income.

Withdrawals prior to age 59½ may be subject to a 10% Federal tax penalty, in addition to applicable income taxes. Surrender charges may apply on certain contracts.

Charles Schwab & Co., Inc., a licensed insurance agency, distributes certain life insurance and annuity contracts that are issued by non-affiliated insurance companies. Not all products are available in all states.

The information presented does not consider your particular investment objectives or financial situation and does not make personalized recommendations. This information should not be construed as an offer to sell or a solicitation of an offer to buy any security. The investment strategies and the securities shown may not be suitable for you. We believe the information provided is reliable, but Charles Schwab & Co., Inc. (“Schwab”) and its affiliates do not guarantee its accuracy, timeliness, or completeness. Any opinions expressed herein are subject to change without notice.

The S&P 500 Index is a market-capitalization weighted index that consists of 500 widely traded stocks chosen for market size, liquidity, and industry group representation.

Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly.

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