Fixed indexed annuities are a great way to put your money to work in a safe and secure way. They are usually sold in the anticipation of market-like returns but there is a lot of misunderstanding about what that actually means. Market-like returns is not market returns which is a good thing and a bad thing depending on how you look at it.
Since fixed indexed annuities are not invested in the market they carry zero market risk. That does not mean there is no risk. Every time you invest money in one place there is always the risk of lost opportunity to invest in other investments that may have been more profitable. For our purposes we have to compare apples to apples.
To compare apples to apples cap rates and payouts come into play. In the equity market or more specifically stock mutual funds the value of your principal goes up and down based on the value of the stocks inside the fund. In an indexed annuity there is no fluctuation. The daily ups and downs as well as the monthly fluctuations do not exist. Only the amount of interest you earn fluctuates and not your principle. In an indexed annuity the interest you earn is only paid out one time per year and in some contracts the payout can be up to once every 5 years.
Do you check your mutual fund values every day? Well you shouldn’t! But that is another topic completely. With a fixed indexed annuity you only get paid one time per year. But how do you get paid? If you are a chronic market watcher then you need to be clear on the fact that you can’t do that with the annuity.
The insurance company has guaranteed that you will never lose money. There are also state guarantees to consider. In order to be able to make that promise they have also put a limit on how much you can earn. The limit comes in two forms but mostly in just one. The first is participation rates and second is cap rates.
Participation rates are still used but seem to be slowly going away with new product offerings. They are still included as a feature because originally they were a big issue and frankly a major deterrent for using indexed annuities. Here is how it works. An 80% participation rate means that if the market earns 10% then you get 8%. A60% participation means that if the market earns 10% you only get 6%. Most indexed annuities do not use participation rates anymore for the simple reason that people just don’t like the idea. While it’s not great it can still be better than losing 40% in the market like a lot of people have in recent years. Cap rates are a little bit different but not necessarily better. They just sound better.
Cap rates are simply a cap on earnings. How they work is much more complicated. Consider there are several different options. Your interest is calculated based directly on your cap rates. If you have an annual cap of 7.5% then that is the most you can earn. If the market goes down then you will earn 0.0% but you will not lose money. If the market is up for the year but more than 7.5% then you only earn 7.5%.
There are several other payout methods that require a little more study. For example the monthly sum method adds up all of the monthly earnings for the year with caps that allow much more possible interest. Some contracts allow a 2-3% monthly cap with is a 24-36% possible earnings with zero loss. Wow! But there is a catch. They also add in every negative month without a cap on the downside. So a 2% gain every month but one is 22% profit but adding in one month of 10% loss lowers the returns to 12%.
How you get paid in a fixed index annuity needs to be clearly understood before investing. With cap rates and participation rates it can be confusing. Comparing cap rates should be essential especially if you already have an annuity with low caps. Newer contracts tend to have other features that make a change worthwhile as well. Be sure to consult with a competent insurance agent before make any changes to your investments.