Fixed equity index annuities have grown in popularity among retirees to the point where as many as 30% of all annuities sold are now indexed to a popular fund, index, or other investment product.
Index annuities are annuities based on the value of another investment product unlike most deferred annuities that are based on a specific rate. For stocks, the most common is the S&P 500 index. An annuity based on the value of the S&P 500 index will rise, but never fall with subsequent one-year changes in the value of the index.
Be advised, the way interest works in fixed equity indexed annuities is different than that of traditional annuities. The insurance company writing the note will buy a one year option in the specific index to be tracked. At the end of the one year term, if the index is up from a year ago, then the option is cashed out, and the proceeds are added to the value of the annuity. At that point the insurance company buys another option for the next year. However, if the index has dropped in the one year term, the option is left to expire and no interest is accrued for that year. You can see why these products are so popular as they offer upside with zero downside. Plus, like all annuities, the growth tax-deferred, so you can rack up profits before ever paying a single dime to Uncle Sam.
Before purchasing a fixed equity indexed annuity you’ll have to decide a total investment period as well as the number of years in which you would like to receive a payout. A popular choice is an annuity that allows for a decade of growth before receiving monthly distributions. For example, if you plan to retire at age 70, then you would purchase the annuity at 60 for regular monthly payments at age 70.
You can, however, withdraw your investment in one lump sum following the end of the growth period. For example, an investor who buys a $100,000 annuity at age 60, which then grows to $200,000 at the end of a 10 year growth period can cash out immediately for the full value of $200,000. Beware, some insurance companies carry heavy fees for cashing out, and you’ll also have to pay capital gains taxes immediately. Regardless, the option is always there to cash out.
Should you choose not to cash out before receiving your monthly payouts, your fixed equity indexed annuity will operate just like any other. You’ll receive monthly payouts that correspond with the size of your annuity investment.
Fixed equity indexed annuities are best used by those who have plenty of time before retirement. Since the returns are generally based on a stock index, you’ll want to have enough time to accrue profits before reaching retirement age. Consider the fixed equity indexed annuity as pre-planning a retirement. It’s like investing in an annuity to later buy an annuity. One thing is different, though, and that is that unlike simple brokerage investments that aren’t included in a retirement plan like a 401k or IRA, the annuity grows tax free.
