Key Takeaways
- Fixed index annuities combine principal protection with growth based on market performance, which might benefit some investors’ risk-return balance.
- Because they are long-term products without direct market participation, indexed annuities reduce the temptation to chase short-term, high-yield assets at the expense of future growth potential.
Fixed index annuities, also known as indexed annuities, are a type of annuity that earns interest based on a fixed minimum rate and a rate tied to an index’s performance. With a fixed index annuity, your money is not directly invested in the market, but you can still accumulate growth if the index tied to your contract performs well.
This balance of upside potential and downside protection can provide an attractive alternative to traditional investing. Investing directly in the market requires a much more hands-on approach, and it’s too easy to make costly mistakes.
According to the CFA Institute, some of the most common investing mistakes include:
- Misunderstanding risk
- Chasing yield
- Focusing on the short term
Indexed annuities can help consumers sidestep these everyday errors while accumulating growth to create income in retirement.
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Misunderstanding Risk
Investing is all about balancing risk and return, and many novice investors make costly mistakes because they don’t understand risk. The CFA Institute reported that investors frequently take on too much, too little or the wrong risk, which can result in lower returns or a more volatile portfolio.
An indexed annuity provides a healthy balance of downside protection and upside potential. When you purchase an indexed annuity, your principal is protected and is guaranteed to earn at least the minimum interest rate, so no matter what, you won’t lose money.
This principal protection comes with a trade-off; indexed annuity issuers employ a few measures to limit the growth the contract can accumulate. An indexed annuity contract might have a cap on the maximum return it can earn or a participation rate that takes only a percentage of the growth of the underlying index.
These limiting features hinder the potential returns of indexed annuities, but they also allow the insurer to assume the risk of protecting the annuity owner’s principal.
Chasing Yield
Another common mistake investors must be aware of is getting distracted from their investing strategy by an attractive, high-yield asset. It’s natural to want to earn the most returns possible, but one must also remember that past performance is no indication of future returns.
Many investors miss out on the best possible returns for their portfolios because they chase after the latest hot new stock. According to the mutual fund polling group Dalbar, the average mutual fund investor only captured 79% of the S&P 500’s gains over the last 30 years.
This is due to investor behavior. As much as we would like to believe we can “time the market” to buy low and sell high, we’re likely to make a few wrong moves that cost us. Trying to outguess how the market will move often results in a worse performance than staying the course.
Because indexed annuities aren’t directly invested in the market, their portfolio allocation can’t be altered by the owner like a brokerage account or a variable annuity might. Once you’ve purchased the annuity, you’re locked in until the surrender period expires, usually after five to ten years.
If you’re concerned about the liquidity of your assets, this might be a problem. However, for investors who want to save for retirement and have time to ride out market fluctuations, an indexed annuity can be a suitable product that combines guaranteed growth and principal protection with the opportunity to capture market gains.
Focusing On the Short Term
Another investing mistake highlighted by the CFA Institute was focusing on the wrong kind of performance. Long-term performance matters most when investing, but it’s hard to see that far into the future.
As a result, investors can get caught up in imagining how their portfolio will perform in the short term. This kind of thinking can lead an investor to deviate from their long-term strategy and make modifications that might provide short-term gratification at the expense of long-term growth potential.
Annuities are long-term products designed to accumulate growth until the owner is ready to convert the lump sum into a stream of income payments. By purchasing an indexed annuity, an investor can set their sights on the far future and avoid the temptation to pivot to a different strategy too soon.
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