If you are thinking of investing for retirement years, there are many options for you to choose from, varying in the amount of risk involved and promised returns. The investment spectrum for retirement planning extends from the ultra safe investment options like treasury bonds, bills and notes, IRA CDs to financial products offered by insurance industries like annuities and beyond.
Annuities come in various types and offer guaranteed income in the long term. In this WealthHow article, I particularly focus on discussing the pros and cons of fixed index annuities, that will help you decide whether it's the right investment option for you.
Right at the outset, before we jump into discussing the advantages and disadvantages of fixed index annuities, let me provide a brief introduction to what are annuities. Probably one of the most sought after financial products offered by insurance companies right now, annuities are effective retirement investment solutions. This is how annuities work. You pay the insurance company a lump sum amount or a fixed amount through installations.
This money stays invested for a fixed period of time and keeps growing with interest, after which the company pays you with a regular income till the end of your lifetime. It is very much like a self funded pension plan. There are various types of annuities and in this article and I introduce you to fixed index or equity indexed annuities in the following lines.
What are Fixed Index Annuities?
Every annuity comes with a fixed interest rate, that determines the amount of returns which the principal investment will generate. In case of fixed indexed annuities, the interest rate of return is linked with the performance of a stock market index like the Dow Jones Industrial average (DJIA) or the S&P 500.
While a minimum interest rate of return is guaranteed by the insurance company, a higher rate of return may be received if the market index performs well. There is a maximum cap on the highest rate of return that might be gained and there are fees involved which are deducted from the total yield received by the investor. Your investment is insured by State Guarantee Funds. Also, your investment is tax deferred till it starts paying up.
Fixed Index Annuities: Pros and Cons
Let us first look at the pros. One of the obvious advantages of a fixed index annuity is the opportunity for higher rate of return, in case the associated index performs well. No matter how the market performs, your minimum interest rate of return is guaranteed. Being insured by the State Guarantee fund, you can be assured that your principal is protected.
These types of annuities provide better returns, than other types of conventional investments like certificates of deposit. Also, your principal investment keeps on growing tax free till you start withdrawing the returns.
Now this was the upside of investing in fixed indexed annuities. Let us take a look at some of the problems with indexed annuities. In case you decide to withdraw your principal invested amount, before maturity, severe penalties are imposed.
So once you are invested in an annuity, you can't touch the money until maturity period. Secondly, the maximum interest cap on returns and fees charged by the insurance company can eat into the profit substantially. That's why it's necessary that you read the fine print carefully, before signing on the dotted line. Consider the reputation and past record of the insurance company before going ahead with the investment.
While fixed index annuities offer the promise of greater returns compared to fixed annuities, as discussed before, the management fees and the maximum cap on interest rates can limit the returns gained through it.
Nevertheless, in comparison they are certainly better investment compared to fixed annuities as they provide the possibility for greater degree of returns. The fact that they are insured by federal authorities makes them safe investments. Read the policy details very carefully and know about the returns and costs involved before buying an annuity as once invested in it, you are in it for life.