Both traditional fixed and index annuities are contract vehicles that offer a guaranteed stream of income upon an initial premium payment. In a volatile stock market like today, these products can alleviate stress and comfort more risk-averse investors.
Since the unprecedented economic shutdown in Spring 2020 due to COVID-19, the stock market has experienced significant volatility. The S&P 500 saw notable declines, with three days in March 2020 registering drops of over 7.75%, yet the index ended the year up over 16%. This growth continued until 2022, when the index fell by more than 15%, marking one of its worst years in decades, alongside a rare decline in the aggregate bond market of over 10%.
Markets are gradually rebounding, though fears of a recession persist due to interest rates reaching levels not seen since 2007. The term “volatile” perfectly captures the uncertainty of this period.
What Are Traditional Fixed Annuities
A traditional fixed annuity provides a guaranteed interest rate for a specified period. These products assure principal protection and offer a steady income stream, appealing to more risk-averse investors. They can be funded with either a single premium payment or a flexible series of payments. The aim is to protect the principal and create a reliable income stream that withstands the stock market’s volatility.
What Are Fixed Index Annuities?
An index annuity shares some characteristics with a traditional fixed annuity but has a unique approach to returns. While both secure the principal, the key difference lies in how interest is earned. Fixed annuities offer compounding returns at a simple interest rate, whereas index annuities provide returns tied to specific market indices, like the S&P 500. The principal is invested in these indices, and the annuitant receives a percentage of the overall return, typically capped at certain maximums. This structure allows for the potential of higher returns compared to fixed annuities but also carries the risk of lower returns, depending on market performance.
Which Annuity Option Is Right for You?
Understanding the nuances between fixed and index annuities is crucial in determining whether an annuity is the right fit for your financial strategy. To make an informed decision, it’s essential to engage in a thorough self-assessment regarding your financial goals, risk tolerance and expected rate of return.
Both fixed and index annuities are suitable for individuals seeking principal protection while aiming for interest rates that can outpace inflation. Annuities are a reliable income solution for those concerned about outliving their assets.
In today’s volatile market, risk-averse clients should approach index annuities with caution. While these products offer principal protection and a minimum interest rate ranging from 1.00% to 3.00%, their performance can vary significantly in adverse market conditions. Currently, fixed annuity rates fluctuate between 5.00% and 5.75%, while index annuities typically yield returns between 4.00% and 7.00%. Although index annuities provide opportunities for higher returns, they also introduce a level of market fluctuation.
If you are comfortable with mild market volatility and seek the potential for greater upside, an index annuity may align better with your objectives. Conversely, if you prefer stable, predictable returns and are anxious about market fluctuations, a traditional fixed annuity would likely be more suitable for your needs. Ultimately, understanding your financial goals and comfort with risk will guide you in selecting the annuity that best supports your financial future.
Risks of Fixed Annuities
When considering annuities as an investment, it’s crucial to understand the associated restrictions and risks. Both fixed index annuities and traditional fixed annuities lock in the allocated premium, limiting immediate access to funds. While withdrawal opportunities exist, doing so early can incur substantial surrender fees.
It’s essential to adopt a long-term perspective when investing in these products. If your primary objective is to achieve high market returns, it may be wise to reconsider the suitability of annuities. Fixed index annuities can provide greater potential for appreciation than traditional ones, but they also come with caps on their upside.
Traditional fixed annuities prioritize stability over high market performance, providing peace of mind with a reliable income stream for life.
Editor Norah Layne contributed to this article.
Frequently Asked Questions
Whether a fixed annuity or an index annuity is “better” entirely depends upon your desired goal. A fixed annuity provides a guaranteed and easily understood rate of return, while an index annuity tracks the performance of a specific market index and offers a higher potential return.
The interest earned in an annuity is tax deferred until withdrawn from the vehicle. At that point, any return of principal is tax-free, whereas any appreciation is seen as a taxable gain at one’s income tax bracket.
The deposited money is relatively illiquid, and the returns are limited or capped. Early withdrawals from the account are also associated with fees. Consult a licensed professional to see if a fixed annuity product suits you.
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