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Life Lessons: Fixed Annuities vs. Indexed Annuities: What's the Difference?

You’ve heard the news that now’s the time to be selling annuities, you’ve done your initial research, and you’ve discovered the two main types: fixed annuities and indexed annuities. But what sets them apart, and how do you know when to market one versus the other? Keep reading, we’ll fill you in.

Generally speaking, Americans near or of retirement age are in trouble when it comes to having enough money saved to live out their golden years worry-free.

According to AARP’s secondary analysis of their 2014 Retirement Confidence Survey, approximately half of American workers age 50 and older and close to 60 percent of retirees age 50 and older had less than $25,000 in their savings and investments. That’s much less than the nest egg amount the experts recommend people save for retirement, which is anywhere from eight to 12 times one’s annual income.

Both fixed and indexed annuities can provide the average person with a safer way to build their retirement savings while protecting those funds from a downturn in the market. Additionally, both can provide a steady, lifetime monthly income, allowing clients to plan their retirement more clearly. But, how do fixed and indexed annuities differ and when should you sell a client one over the other? We’ll gladly explain.

FIXED ANNUITIES
Let’s start with the basics. By and large, fixed annuities are very straightforward and easy to understand.

A fixed annuity is a contract between your client and the insurance company that guarantees both the principal and the rate of return on your client’s investment. Similar to a bank CD, fixed annuities are very low-risk investments that are not affected by the ups and downs of the stock market.

A fixed annuity can be immediate or deferred. Immediate annuities allow the client, or annuitant, to begin receiving payments the month after they open the annuity. Conversely, deferred annuities postpone the annuitant’s payments until a future date to allow time for growth of the principal.

The most important benefit of fixed annuities is that they typically provide much better interest rates than bank CDs and can provide lifetime payouts after retirement. Interest rates for fixed annuities remain the same for the full length of the contract, and the interest earned is tax-deferred until payments begin.

INDEXED ANNUITIES
Indexed annuities, sometimes referred to as equity-indexed annuities, are much more complex than fixed annuities. Why? This type of product offers features of both fixed annuities and variable annuities and is tied to the stock market.

Because the return for an indexed annuity is based on one or more indexes, its interest rate will vary throughout the contract. As with fixed annuities, an indexed annuity usually offers a guaranteed minimum return, typically between 1 percent and 3 percent, even if the index it’s tied to does poorly. However, a major benefit of indexed annuities is that, if the index is performing well, the annuitant has the potential to earn much higher interest rates.

An indexed annuity has many intricate parts, such as the index it’s tied to, the participation rate or spread used to determine interest calculations, cap rates, and high surrender charges. It’s important that your client thoroughly understands the product they are purchasing, its benefits, and its limitations.

INTEREST CALCULATION
Interest calculation for fixed annuities is basically unnecessary since interest rates are locked-in for the life of the contract. Conversely, interest on an indexed annuity typically follows one of the index crediting methods below. Sometimes, the calculation may involve a combination of these crediting methods.

  • Interest Rate Caps—Some indexed annuities use a cap to determine how much interest will be credited in a given time frame. For example, if the annual cap rate is 5 percent for a particular year and the index that the client’s annuity is linked to gains 8 percent, the client would receive only 5 percent interest that year. If the indexed only gains 4.5 percent, the client would receive the full 4.5 percent interest for that year.
  • Participation Rates—Another common interest crediting method, a participation rate defines how much of the rise in the given index will be credited to the client for each predefined period. For example, if the client’s participation rate is 60 percent and the index rises 14 percent that year, the client would be credited 60 percent of that rise, or 8.4 percent interest.
  • Spreads—A spread or asset fee can be used either in combination with or instead of a participation rate. The spread is usually defined as a percentage and will be subtracted from any gain in the index. For instance, if an index gains 8 percent in a given year and the client’s defined spread or asset fee is 4 percent, this would result in credited rate of 4 percent for the client.

GUARANTEED MINIMUM INCOME BENEFIT RIDERS
An enticing feature now included with many indexed annuities is a rider guaranteeing a minimum annual income based on a specified interest rate. The Guaranteed Minimum Income Benefit Rider (GMIB) only applies if a client annuitizes his contract. How does it work?

An annuity with a GMIB has two separate account values—the actual market value of the annuity, which is based on the performance of a specified index, and the GMIB account value. The GMIB account value is hypothetical and is only used to determine the amount of income the annuitant will receive when he or she elects to begin receiving annual income. GMIBs usually offer a guaranteed percentage of annual interest for a specific number of years, for example, seven percent guaranteed annual interest rate for the first ten years of the policy. It is important the client understands that this guaranteed rate is not credited to the actual market value of the annuity, cannot be withdrawn, and is only the hypothetical GMIB account value.

GMIB riders usually have a rider fee associated with them. However, if your client intends to annuitize the policy and use it as retirement income, a GMIB rider offers a guaranteed minimum income amount that will much likely be higher than the income amount from an actual market value account without the rider in place.

SURRENDER CHARGES
For both fixed and indexed annuities, the annuitant will incur surrender charges if he cancels his contract, or withdrawals an amount of money in excess of a penalty-free withdrawal allowance for a given year, during the annuity-specific surrender period.

The surrender periods for both fixed and indexed annuities are usually equal to the length of the contract. Fixed annuities often have surrender periods that are for three, five, seven or ten years. Indexed annuities have surrender periods that also vary in contract terms, with the most common being ten years and the longest being twelve or fifteen years.

If an annuitant chooses to cancel his contract prior to the end of the surrender period, hefty surrender charges will apply. The surrender charges for both types of annuities can be as much as 10 percent. These charges will vary between carriers, but usually decline over time, typically 1 percent per year.

DETERMINING THE BEST FIT
Overall, fixed annuities are an excellent option for seniors who don’t want to take on the risks of the unpredictable stock market but want to achieve higher interest rates than their bank CD can provide. And due to their more complicated nature, indexed annuities are more suited for savvy investors, and typically your younger clients looking for more of a return on their investment without taking on much risk. But keep in mind, while an indexed annuity can be a great vehicle for a client looking to maximize his return, it’s not a good fit for everyone.

You, as the agent, must assess your client’s interests, knowledge, and financial situation. If your client has little interest in the stock market or how it works, and has never had investments tied to it, an indexed annuity is most likely not the right product for that client. However, if your client appears to be stock market-savvy, understands the product, and has clear expectations about potential future earnings and possible charges, definitely discuss an indexed annuity as a possible building option for your client’s retirement savings.

As a general rule, the more informed your client is, the happier they will be with their investment. The Financial Industry Regulatory Authority (FINRA), has developed an Investor Alert explaining indexed annuities via an easy-to-understand, generally unbiased approach. Providing this alert to your clients will allow both you and your client to discuss and determine if an indexed annuity is right for them.


For more information on the various annuity products available to you through Ritter Insurance Marketing, please contact Jed Karpinski at jed.karpinski@ritterim.com or 800-769-1847 ext. 226.

* Annuities

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