As you approach retirement age, you are more likely to look for asset protection and minimal risk than you are for aggressive investments that can potentially give you a high rate of return. Unfortunately, traditional “safe” savings and investment options, such as FDIC-insured certificates of deposit (CDs) and government bonds, don’t always have a high enough interest rate to keep up with inflation. Fortunately, there is a way to invest your money for retirement, earn a decent return, and enjoy minimal risk. A fixed annuity, sometimes called a fixed index annuity, can provide you principal protection from stock market losses with a guaranteed rate of interest each year.
If you’re nearing retirement, there are a few reasons why a fixed annuity can be a worthy addition to your portfolio. Schedule a consultation with Nicholas Wealth Management today and we’ll help you navigate the waters of retirement and see if a fixed annuity fits in with your financial goals.
How Fixed Annuities Work
A fixed annuity is a type of guaranteed insurance contract made between you and an insurance company. When you enter into the contract, you provide the insurance company with a lump-sum payment. The insurance company promises to keep your principal payment secure for a set number of years, anywhere from one to forty, but usually between five and fifteen years. In return, you receive principal protection and a fixed amount of interest each year or interest based on the upside performance of a stock market index.
Like the principal you’ve invested, the interest earned on a fixed index annuity isn’t subject to the forces of the stock market. That means your principal and earnings won’t fall when the market falls. Additionally, the earnings on an annuity are tax deferred, meaning you won’t pay taxes until you start taking withdrawals.
Interest from a Fixed Annuity
How much interest can your fixed annuities earn? It all depends on the type of interest-crediting option your plan offers. Some annuities have a cap on interest, which puts a limit on the amount of interest the principal earns. While that can seem like a negative thing, there are positives to a rate cap, according to the National Association of Insurance Commissioners. Annuities that have a cap often allow for early withdrawals, have a higher participation rate, or offer annual interest crediting. The participation rate determines how much of the gain is credited to the annuity. The higher the rate, the more interest the annuity earns. Some fixed index annuities currently have annual caps of 5% per year. For example, if a stock market index that was selected in the contract were to go up 6% in any one year, your interest would be capped at 5% for that contract year. If the stock market index were to be negative the following year, you would not lose the 5% interest the contract earned in the prior year. If the contract is held to maturity, your principal and interest is protected from stock market losses.
As Investopedia notes, fixed annuities can also have a guaranteed minimum interest rate. The minimum rate offers you some protection in case interest rates drop precipitously while your annuity is in the accumulation phase.
Drawbacks of Fixed Annuities
Although fixed annuities offer more security than investing in the stock market and a better rate of return than CDs or government bonds, it’s important to remember that no investment vehicle is entirely perfect. One of the catches of a fixed annuity is that you agree upfront to a certain time period you will hold the annuity contract for. Most contract lengths run between five and fifteen years. During the initial time period many plans allow you to withdraw up to 10 percent of the principal or account value each year. However, should you need to withdraw more than 10 percent in any one contract year, you’ll pay a penalty fee known as a surrender charge. After the initial time period is up, contract holders can withdraw 100 percent of their annuity’s value without any penalties.
Like all insurance, the guarantees that the fixed annuity provides are solely backed by the claims paying ability of the issuing insurance company. The best way to protect your investment is to pick an insurance company that has strong financial ratings. You can also contact your state’s insurance commissioner’s office to see if your state offers a guarantee should your insurance company fail, as US News and World Report points out.
When you invest your retirement savings in stocks or mutual funds, there’s a risk that the money will run out while you still have many years left of life. Fixed annuities provide principal protection from stock market losses and many can provide a “paycheck for life.” As long as you keep on ticking, your fixed annuity is going to keep on ticking — and paying.