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Financial Planning with Fixed Indexed Annuities

Fixed indexed annuities (FIAs) can be a useful tool for accumulating and protecting retirement savings. For instance, you could invest a conservative portion of your portfolio in an FIA and get some protection while earning tax-deferred returns that may compare favorably with certificates of deposit (CDs) or Treasuries.

For more on fixed indexed annuities, read Using Fixed Indexed Annuities for Lifetime Income.

The basics: What is a fixed indexed annuity?

You can think of an FIA as another tool in your retirement-savings toolbox: you can use it to accumulate tax-deferred savings for retirement alongside a 401(k) or individual retirement account (IRA). When contributions are made with after-tax dollars, you pay no taxes on the gains until you make a withdrawal, surrender, or annuitize the contract. At that point, gains are taxed as ordinary income (which could include the 3.8% net investment income tax or a 10% penalty tax if event occurs before age 59 ½).

Fixed indexed annuities differ from other investments, such as CDs or bonds, in that they are insurance products, not investment products. When you buy one, you turn a lump of your savings over to an insurance company, who bases the performance of the FIA to an underlying index, such as the S&P 500® Index. In exchange, the insurance company guarantees that your original principal won’t fall in value (so long as you don’t make early withdrawals and depending on the financial strength and claims-paying ability of the insurer).

As you’ll see below, the mechanism used to determine the returns of a fixed indexed annuity makes FIAs unique. However, because the details can vary by product or contract, it’s critical to understand the details before buying.

A fixed indexed annuity can have higher return potential than a CD or a high quality bond because they tend to 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. If a FIA’s selected stock index rises, then the rate of return on the fixed index annuity can also rise. The FIA does not represent an investment directly in the market. (Though, gains are usually capped, as we’ll see below. And the index tracked may not include dividends, only the change in market price of the index tracked.) If the index falls, the investor generally won’t earn any interest, but the FIA protects the principal.

If you're shopping for a fixed indexed annuity, understanding the formula behind the potential returns on offer is key. One criticism leveled against FIAs is that the formulas are complex. This is often true, and in some marketing, FIAs may be presented as delivering “market participation with no risk.” If you do your homework and talk with an annuities specialist, you can go a long way toward avoiding surprises.

The following hypothetical case studies don’t cover all the possible formulas, but they may give a sense of how one type of FIA works.

Have specific questions about annuities? Speak to a Schwab Annuity Specialist by calling 888-311-4889

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. This 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 fixed indexed annuities 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 in year 1 and makes no early withdrawals. Her contract caps her rate of return at 5%.

The table below shows where she might have ended up.

Year

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Year 9

Year 10

S&P 500 Index return

3.5%

-38.5%

23.5%

12.8%

-1.0%

13.4%

29.5%

11.4%

-0.7%

9.5%

1-year-point-to-point

Percent credit to FIA contract value

3.5%

0.0%

5.0%

5.0%

0.0%

5.0%

5.0%

5.0%

0.0%

5.0%

Contract value

$103,500

$103,500

$108,675

$114,109

$114,109

$119,814

$125,805

$132,095

$132,095

$138,700

Source: Schwab Center for Financial Research. Assumes 1-year-point-to-point with a 10-year initial guaranteed period and 5.0% annual cap. Assumes no insurance charges, management fees nor additional rider fees. If $100,000 were invested in the S&P 500, the year-end values for year 1-10 would be $103,530, $63,685, $78,622, $88,672, $88,670, $100,556, $130,322, $145,167, $144,112, and $157,853. S&P 500 return assumes annual rebalancing and does not assume taxes, dividends, or other fees. The example is hypothetical and provided for illustrative purposes only.

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 3.5% Year 1, her interest rate was also 3.5%. When the index rose 11.4% in Year 8, Lisa earned the 5% limit.

In years when the index fell, her principal held steady. Overall, her average annualized return in the hypothetical example was 3.0%—less than the 4.2% average annualized return she might have earned from an investment that tracks the S&P 500—but she also wouldn’t have faced any losses during the severe drop in the market in Year 2 and small negative returns in Year 5 and 9.

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

Some fixed index annuities 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. She chose 4.6% to weight the importance of downside risk, the declared interest rate of the annuity and fixed rate alternatives available over the upside potential and the 5% cap. 

Year

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Year 9

Year 10

S&P 500 Index return

3.5%

-38.5%

23.5%

12.8%

-1.0%

13.4%

29.5%

11.4%

-0.7%

9.5%

1-Year-Point-to-Point (assumes 10-year initial guaranteed period and 5.0% annual cap)

Percent credit to FIA contract value

4.6%

0.0%

4.6%

4.6%

0.0%

4.6%

4.6%

4.6%

0.0%

4.6%

Contract value

$104,600

$104,600

$109,412

$114,445

$114,445

$119,709

$125,216

$130,976

$130,976

$137,001

Source: Schwab Center for Financial Research. 

As you can see, in years when the S&P Index rose, Lisa received the declared interest rate of 4.60%, and . in years when it fell, her principal held steady. 

When a fixed indexed annuity 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 a fixed indexed annuity 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 a 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.

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Important Disclosures

Investing involves risk including loss of principal.

Unlike a CD, which is a FDICinsured bank product, an annuity's guarantees of principal and interest are only as strong as the financial strength and claimspaying ability of the issuing insurance company. Consult an insurance company's ratings for its financial strength, and read its contract before investing. Neither Schwab nor its affiliates provides insurance guarantees.

CD earnings are taxable the year the interest is earned, even if you don’t withdraw the money at that time. In contrast, earnings from fixed deferred annuities are not taxed until they’re withdrawn. For specific tax advice, consult your tax professional.

CDs may incur an interest penalty from 30 days to 6 months of interest. If renewed after the initial holding period, the penalty period restarts. Fixed deferred annuities Withdrawals are subject to income taxes and, if made prior to age 59½, a 10% IRS penalty tax may apply. Surrender charges, and other restrictions may apply.

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.

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.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Investment value will fluctuate, and bond investments, when sold, may be worth more or less than original cost. Fixed income securities are subject to various other risks, including changes in interest rates and credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. High-yield bonds and lower-rated securities are subject to greater credit risk, default risk and liquidity risk.

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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