What Is a Fixed Index Annuity?
A fixed index annuity (FIA) or equity indexed annuity is an insurance contract that combines principal protection with potential market-linked returns. If the chosen market index that’s linked to the annuity performs well over the course of the year, the annuity holder enjoys a portion of those gains as interest. An annual reset is the mechanism by which those gains are “locked” into the accumulated value of the annuity, ensuring the interest is protected from potential market downturns in the future. A financial advisor can help you determine whether an FIA or other annuity is appropriate for your retirement plan.
What Is an Annual Reset?
At its core, an annual reset aims to provide investors with the opportunity to benefit from market growth while safeguarding their principal against market downturns. An FIA’s performance is typically tied to a chosen market index, such as the S&P 500. However, unlike direct investment in the stock market, the annuity doesn’t involve purchasing stocks. Instead, it offers the potential for interest credits that are based on the index’s performance.
Each year, on the anniversary of the annuity contract, the insurance company examines the index’s value. The annuity’s credited interest is determined by measuring the index’s performance from the beginning of the contract year to its end.
If the index shows growth, a portion of that growth – subject to certain limitations known as “caps” or “participation rates” – is added to the annuity’s value. Importantly, even if the index experiences a decline during the year, the annuity’s principal remains protected from those losses.
How an Annual Reset in a Fixed Index Annuity Works
At the end of the tracking period, the annuity’s value is reset based on the positive performance of the chosen index. This means that the gains achieved during the year are locked in and the new value becomes the starting point for the next tracking period.
Over time, the annuity’s value has the potential to compound as gains from previous years are added to the accumulated value. This compounding effect can lead to significant growth in the annuity’s value, especially during periods of consistent market growth.
But even if the market index experiences losses in subsequent years, the annuity’s value remains unaffected by these downturns. When this happens, your annuity resets the index to the reduced value on the contract anniversary, essentially automatically buying low. The process of annual resetting and compounding repeats each year, allowing your annuity to capture market gains while staying shielded from losses. This cycle continues yearly.
Example of an Annual Reset
An investor owns a fixed index annuity with an annual reset and a current value of $10,000. The strategy has a 12% cap on the index selected and the specified market index posted a 7% return at the contract year’s end. As a result, the annuity’s value would increase by 7% to $10,700. If the index posted higher than the 12% cap the annuity would be limited by the cap of 12%. This is often described as 12% cap with 100% participation.
If the annuity contract includes a participation rate, only a portion of the 7% gain would be credited to the accumulation value. If the annuity in the example above had a 50% participation rate, the accumulated value would increase by 3.50%. This is often described as 50% participation uncapped.
Pros and Cons of an Annual Reset
The annual reset feature brings both advantages and potential drawbacks to investors.
Pros
* Market upside participation: The annual reset allows policyholders to benefit from market upswings, as gains are locked in periodically. This potential for growth can help counter the effects of inflation.
* Principal protection: Even in a downturn, the annuity’s value is shielded, as the annual reset prevents losses from being carried forward. This protection provides peace of mind for risk-averse investors.
* Eliminate Advisory Fees: Advisors or agents are compensated directly by the issuing insurance company with full disclosure eliminating traditional 1-2% annual advisory fees associated with managed accounts.
Cons
* Capped returns: Some FIAs impose a cap on potential returns to mitigate risk for the insurer. As a result, policyholders might not fully capitalize on market gains.
* Limited liquidity: Annuities often have longer surrender periods from 3 to 10 years, and accessing funds before the term can lead to penalties. This lack of liquidity might not suit those requiring immediate access to their money. Most annuities offer 10% “Penalty free” withdrawals to meet liquidity needs during contract period. If you need access to more than 10% annually, an annuity may not be suitable.
* Complexity: The calculations involved in annual resets can be intricate, making it crucial for policyholders to fully comprehend how their annuity functions. By selecting an annuity without any riders the contracts are simplified.
Bottom Line
The annual reset feature of a fixed index annuity provides an intriguing balance between market-linked growth and principal security. While it offers the potential for higher returns, it’s important for individuals to consider their risk tolerance, financial goals and the annuity’s terms before making any decision.
Chart above is not a specific offer. Provided only for educational purposes. EXAMPLE of UNCAPPED 50% Participation of S&P500 price index with NO Spread and NO Riders.
PRINCIPAL PROTECTED INDEXING STRATEGIES
Gain the confidence to participate in market indexes without risking your current balances. Indexing can protect principal while linking only the interest from the principal to the volatile market. The financial instruments used allow participation in market index gains while eliminating the possibility of loss due to negative markets. By strategically resetting at precise periodic intervals, returns are realized and locked in and can never be lost to the market. With stocks and mutual funds, one can't own the instrument and the gains simultaneously. To lock in a gain, you have to sell the investment. Then what do you do? Let us show you how you can own both the strategy and the results (gains) simultaneously. This eliminates a lot of difficult emotional decision-making and protects you from taxes. Traditionally one would have to sell to lock in a gain. Since this is not required, no taxable event takes place.
IRAs, Roth IRAs, 401k rollovers as well as non-qualified dollars can all benefit from these plans.