Fixed Index Annuities Pros and Cons

Introduced in the 1990’s, an era of decreasing interest rates and increasing market volatility, fixed index annuities were designed to meet the growing demand for higher fixed rates by timid investors. Today their popularity continues to increase along with stock market volatility and diminishing interest rates. They have not been without some controversy over their complexity as an investment vehicle and their high costs. While they can be an excellent alternative for the right person, prudent investors should carefully consider the pros and cons of fixed annuities.

Fixed Index Annuity Basics

At their core, fixed index annuities offer investors the opportunity to participate in the gains of the stock market while limiting their downside risk. Offering a minimum rate guarantee, they provide investors with the assurance that, no matter how much the market may drop, they will still receive a positive return on their investment.

Unlike variable annuities in which funds are invested into the market via managed stock and bond accounts, fixed annuity returns are generated through participation in the increase of market indices year over year. For example, if the market index to which the annuity is tied increase by 15% over a year, the fixed annuity account will earn a portion of that. The actual amount earned is based on the participation rate and earnings cap (explained in more detail below) of the particular annuity.

As an annuity contract, they also enable investors to defer taxes on the accumulation and can be converted to a guaranteed stream of income for life. As with all annuities, they are structured with surrender periods and fees that discourage investors from withdrawing their funds in the first five to ten years of the contract. Withdrawals are allowed without a surrender fee as long as they don’t exceed 10% of the balance.

A Look Inside of Fixed Index Annuities

Up to this point, fixed index annuities would seem like not only a remarkable investment vehicle for the right investor, but also a great annuity innovation that offers the best of all worlds. The reality is that there are several components that go into a fixed index annuity that make it a bit more complex, and this is where an prospective investor really needs to understand the pros and cons of each.

Minimum Rate Guarantee

Not unlike most annuities, fixed index annuities include a minimum rate which is credited no matter if the stock market declines.

Pro: You can’t lose principle and you have a bare minimum expectation
Con: None to speak of especially considering that the alternative is to earn a negative return if the market falls.

Participation Rate

Investors will participate in only a portion of the index gain based on a percentage established by the insurer called a participation rate. The higher the rate, the greater the participation in the gain. For example, if the market gains 10%, and the participation rate is 70%, the percentage gain credited to your account is 7%.

Pro: The potential to earn returns greater than typical fixed annuities and participate in the growth of the market.
Con: Some participation rates can be somewhat low, 30 to 50%, and high participation rates are not usually guaranteed for a long period of time, so it’s easy to be lured by a high rate only to have it cut severely in the future.

Cap Rate

Fixed index annuity contracts include a cap on the amount of the gain that they will credit to the account. The cap rates are based on a formula or a fixed number and are determined at the issuance of the contract (but can be changed by the insurer). So, for example, if the market gains 20% and the cap rate is 10% the insurer will credit your account with 10%. Both the cap rate and the participation rate are used by the insurer to protect their downside when the market declines, and also, to create a “spread” that will ensure that they can make a profit.

Pro: Depends on your perspective and expectation. For timid investors who can’t stomach downside risk, a piece of the pie is better than none at all.
Con: Some cap rates can be low and high caps can be changed.

Annual Reset

One of the truly attractive features of an index annuity is the reset feature whereby the gains in the account value are locked in and form the new basis of the contract. Accounts are reset each year on the anniversary.

Pro: You have the assurance that your account values will not suffer a loss.
Con: None

Surrender Period

Surrender periods are common to annuity contracts. This is the period of time that the insurer requires that you keep your funds in the account or else be charged a surrender fee. Typically, the surrender periods last for the first seven to ten years of the contract and the fees are percent of the amount withdrawn in excess of 10%. The fee percentage declines by one point a year so it will eventually disappear.

Pro: You have some flexibility to access your funds, and eventually withdraw all of it without penalty (beware of the 10% IRS penalty for pre 59 ½ withdrawals).
Cons: Who likes to pay fees? But an investment in annuity should only be made with a long term time horizon. An early withdrawal could also affect your reset which could mean a loss of account values.


As with any investment there are going to be pros and cons that must be weighed in light of your specific financial situation. The common complaint about fixed index annuities is their limited upside potential. However, if your expectation is to be able to generate returns that are better than the ones you can get from fixed yield investments or savings with the same degree of safety, then fixed index annuities may be an attractive option.

Traditional vs Roth IRAs

Ever since the introduction of Roth IRAs in 1997, the debate over Traditional IRAs vs Roth IRAs has raged non-stop, and is likely to continue for as long as the choice remains. One thing is certain, the choice an individual must make between the two is not a simple one as the rules and requirements, and outcomes of each are different and it should rely heavily on their own personal circumstances. The best course is to gain an understanding of how each works and what sets them apart from each other.

Traditional IRA Basics

Traditional IRAs have been around for a long time, so most people are familiar with them. Established by Congress to encourage individual retirement savings, Traditional IRAs enable individuals to save for their future by making tax-deductible contributions of up to $5,000* that can be invested in a number of ways to accumulate a nest egg that isn’t taxed until it is withdrawn, presumably at a lower tax rate in retirement. Any withdrawals made prior to age 59 ½ also be subject to a 10% penalty unless certain requirements are met.

Roth IRA Basics

Contributions made to a Roth IRA are not tax-deductible but can be invested in the same way as a Traditional IRA and allowed to grow without current taxation. The biggest difference between the two is that, with the Roth IRA, distributions are not taxed, and, although they may be subject to the same early withdrawal penalty, there are provisions that allow for withdrawal of principle at any time without penalty.

Other Key Differences between Traditional IRAs and Roth IRAs


Traditional IRAs:

Anyone who does not currently participate in another qualified retirement plan such as an employer-sponsored plan is eligible to contribute to a Tradition IRA. Those who do participate in another qualified plan may contribute to a Traditional IRA if their income doesn’t exceed a certain amount which, for a single filer is $60,000 and joint filers $100,000.

Roth IRA:

Anyone can contribute to a Roth IRA regardless of whether they participate in another plan as long as their income doesn’t exceed a certain income range which for single filers is $95,000 and $110,000 and joint filers $150,000 to $160,000. The contribution limit is reduced once a person’s income enters the range and then is disallowed completely when it exceeds the range.


Traditional IRA:

All distributions from a Traditional IRA will be taxed as ordinary income. Any early distributions are subject to a penalty unless they meet certain requirements such as: Recipient is deemed disabled and cannot work; funds are used as part of a down payment on a first-time home purchase; funds are used to pay for college expenses; or they are distributed based on a schedule of equal periodic payments for life.

Roth IRA:

All distributions received from a Roth IRA are tax exempt. Early distributions are allowed to the extent that they are from the principles which are drawn out before interest. Also, distributions cannot be taken until the 5-tax year hold period has been met, meaning, the initial contribution to a Roth has to be held in the account for at least five years based on when the contribution was actually made. The same early withdrawal penalty exclusions that apply to Traditional IRAs apply to Roth IRAs.

Minimum Distribution Rules

Traditional IRA:

Distributions must commence by age 70 ½ and be sufficient to pay out the total balance by life expectancy.

Roth IRA:

There are no minimum distribution requirements.

Estate Taxation

Traditional IRA:

Distribution to beneficiaries are included in the estate for estate tax purposes, and they are also taxed to the beneficiary as ordinary income.

Roth IRAs:

Also included in the estate but not taxed to the beneficiary.

Which is Best?

While the Roth IRA holds some clear advantages over the Traditional IRA in terms of eligibility and distribution flexibility and taxation, the answer still lies in which one is best for your particular situation. For most people, the Roth IRA is likely to produce the best outcome. For example, a person who begins contributing at the age of 37 and is in a combined federal and state tax bracket of 33%, would generate about $700 more monthly income from a Roth than an IRA (assuming an 8% average return on investment and a 15% tax bracket after retirement).

Should I Change to a Roth?

If you have a Traditional IRA and are considering changing or converting it to a Roth IRA, you should be aware that the conversion will trigger a taxable event, which could impact the ultimate outcome. The amount of money that your move from a Traditional IRA into a Roth in excess of your principle will be taxed in the year of the conversion at your ordinary income tax rate. The tax can be paid directly from your IRA or with funds that you have available elsewhere. Either way, it will have the effect of diminishing your long term returns.

An alternative to consider is to simply cease making contributions to your Traditional IRA and start making them to a Roth. The only problem is that you will then have two different IRA accounts which can be more troublesome to administrate.


With all of the moving parts of both a Traditional IRA and a Roth IRA and the difference of each, it would be important to compare both with careful consideration of your current and future financial needs. Your best advice is to run some comparison using any number of IRA calculators available online that will help you determine which will produce the best outcome at retirement.

*Current limit for IRA contribution. Future limits will be indexed or increased by increments of $500

Lifetime Annuities for Dummies

Lifetime annuities have been around since ancient times when Roman citizens and soldiers turned over lump sum payments to the Emperor in exchange for an annual stipend to be paid over their lifetimes. Since then the lifetime annuity concept has found its way into corporate and government pension plans, and into the modern marketplace of retirement investment alternatives. Retirees who have been pinched by declining values in their 401(k) plans are turning to lifetime annuities to add more security in their lifelong need for income. In spite of their long history, and their growing popularity, lifetime annuities are still an enigma to most people, so here is a primer on lifetime annuities explained for dummies:

The Lifetime Annuity Concept

Lifetime annuities are a form of insurance contracts issued by a life insurer. Instead of providing protection against the risk of dying to soon, they protect individuals against the ever increasing possibility of outliving their retirement income sources. So, whereas the purpose of life insurance is to create capital in the event of death, the lifetime annuity’s purpose is to distribute capital as periodic payments over a prescribed period of time or for a person’s lifetime. In the case of a lifetime annuity, the life insurer assumes the risk of the individual living too long.

How does a Lifetime Annuity Work?

Money in

An individual makes a lump sum deposit to a life insurance company which then uses actuarial assumptions to determine the amount of income that can be paid out, typically on a monthly basis, for the person’s lifetime, or for a specified period of time. The key factors used for determining the payout rate are the age of the individual, the individual’s life expectancy (taken from actuarial tables), the amount of deposit, and the current cost of money (interest rate). From this, the insurer establishes a payout rate which is fixed for the whole term of the contract.

Note: Once the payout period begins, anytime between 30 days or one year after the deposit, the conversion to income become irrevocable, which means that the individual no longer has access to the principal.

Money out

The payout, which typically comes in the form of a monthly income payment, consists of interest earned on the principal as well as a return of the principal itself. The insurer has calculated the payout so that the whole principal balance will be returned to the annuity owner by the end of the payout period which could be a specified number of years or for the individual’s life expectancy. Should the individual live beyond life expectancy, the insurer will continue the payout even though the principal balance may have already been exhausted. This is the risk that the life insurers assume with lifetime annuities.

Have it your way

Lifetime annuities can come in different shapes and sizes depending on the individual’s needs and financial situation. A single individual might use a single life form which simply pays out a fixed amount of income for the life of the individual. An individual who is married could use a joint and survivor arrangement whereby the annuity payments would continue to be paid after the death of one of the spouses. The payout on a joint life annuity will be slightly lower than a single life annuity the difference of which the life insurer uses to insure the risk on the second life.

A refund option is available that, in the event the annuitant dies prematurely, will pay the remaining balance to a designated beneficiary in the form of installment payments. Selecting a refund option will also lower the payout rate slightly.

Is a Lifetime Annuity Right for You?

People nearing or at retirement look to lifetime annuities for their security and predictability. No other retirement vehicle can securely guarantee an income that cannot be outlived, so lifetime annuities are very unique in that regard. Still, they are not for everyone. While it is important to know how lifetime annuities work, it is even more important have a thorough understanding of your own needs and financial situation to determine if they are right for you.

If you find yourself in one or more of the following situations, a lifetime annuity may be suitable for you:

You are concerned about outliving your income sources –

At the same time 401(k) account values have been declining, life expectancy has been expanding creating a perfect storm of concern over having the financial resources necessary to sustain an income over 25 or 30 years.

You have a sufficient amount liquid assets –

A lifetime annuity is irrevocable. Once it starts, your principal is committed to the life insurer, so it’s vital that you have funds in short term investments or savings that can be used for emergencies and other unexpected expenditures.

You are retired –

Or, better yet, you are able to wait until sometime into your retirement to begin income payments. The longer you can wait, and the older you are, the higher the income payout.

You want to remain invested in stocks and bonds after you retire –

Many retirees today are willing to assume some risk in order to keep their assets growing. By combining an investment portfolio with a lifetime annuity, they can be assured of a stable income during market price fluctuations.

Compare Before You Buy

Lifetime annuities are offered by dozens of life insurance companies, so there is a lot of room for comparison. It’s fairly easy to compare lifetime annuity products because you are simply comparing payout rates. Payout quotes can be obtained easily by phone or online. The most critical factor for comparison, however, is that strength and stability of the life insurance company which is the basis of your guaranteed income stream. It is strongly suggested that you restrict your comparison to only the most highly rated insurance companies (A rated or better by A.M. Best or Moody’s).

Deferred Annuities for Dummies

When it comes to deferred annuities, most people might classify themselves as “dummies” if only for the fact that they are fairly unique in the realm of investment products.  While the basic concept of a deferred annuity is simple – In exchange for a deposit of funds from an investor, a life insurer promises to credit a competitive rate of interest over the phase period and then guarantee a lifetime income payout during the distribution phase – there are a lot of moving parts within an annuity contract to make sure that all of that happens.  Herewith is an explanation of deferred annuities for dummies.

The Basic Premise of Deferred Annuities

An annuity is a legal contract issued by a life insurance company because it is a form of insurance protection.  Instead of insuring against the risk of dying too soon, and annuity insures against the risk of living too long. In other words, by contract, a life insurance company will guarantee that you cannot outlive your principal.

Annuities have existed for thousands of years as binding contracts between a private or government entity and individuals wherein a promise to pay the individual annual payments for a specified period of time, or a lifetime, was made in exchange for lump sum deposit of money. The purpose of the modern annuity, a product of life insurance companies originally offered in the 19th century, evolved so that it could also be used to accumulate funds prior to the need for income.  These became known as “deferred” annuities because the income was to be deferred until a later time.

How a Deferred Annuity Works

A deferred annuity is comprised of two distinct phases: An accumulation phase which begins once the annuity owner’s funds are on deposit with the insurer; and a distribution phase which begins once the owner annuitizes, or converts a lump sum of money to an income stream.

Accumulation Phase

The key components of the accumulation phase are the accumulation account, a credited interest rate, a minimum rate guarantee, withdrawal provisions, and the death benefit.

Accumulation account:

Each annuity contract creates an account in which an investor makes a deposit and the funds accumulate.  Although the account is established in the name of the annuity owner, the funds become a part of the life insurer’s general account which is invested in secure vehicles such as long term government bonds.

Credited interest rate:

In return for the lump sum deposit, the life insurer credits the account with a fixed rate of interest.  In some deferred annuities, the rate of interest is guaranteed for a certain period of time, after which it is adjusted to the prevailing rates at the time or a minimum rate whichever is higher. The insurer generally credits a rate of interest that is based on the yield it generates from its own investment portfolio and the rates are typically higher than those found in bank CDs and other short term fixed vehicles.

Minimum rate guarantee:

After the initial or guaranteed rate period, the insurer will adjust the rates according to a formula. Most deferred annuity contracts include a minimum rate guarantee which prevents the adjusted rate from falling below it.

Withdrawal provisions:

Deferred annuity contracts allow for an annual withdrawal of funds up to 10 percent of the account balance without incurring a charge.  The charge, known as a surrender fee, is based on a percent of the funds withdrawn that are in excess of 10 percent of the balance, and can range from 5 percent to 10 percent in the first year of the contract. Each year the fee declines by 1% until it eventually disappears, after which there are no more withdrawal fees.

Death benefit:

Because annuities are an insurance contract, they include a death benefit which pays a lump sum of the accumulated values or the principal whichever is greater to a designated beneficiary.

Distribution Phase:

The key components of the distribution phase are the lump sum of principal, the payout rate, and the refund option.

Lump sum of principal:

During the accumulation phase, the funds are left to accumulate until the owner has a need for income. The accumulated balance then becomes the principal amount that is annuitized for income. Once the principal amount is annuitized, converted to income, the annuity owner no longer has access to the principal and can only receive it back through the annuity payments.

Payout rate:

This is the rate at which the insurer will determine how much income can be generated from the principal amount. The insurer factors in the amount of principal that is repaid as part of the income payments, the length of the payout period – either a specified period of time or the life expectancy of the annuitant, a minimum interest rate, and the income ownership (single or joint life) to arrive at the rate which is then fixed for the life of the annuitant. The shorter the annuity period the higher the payout rate and the higher the amount of principal that is paid as part of the monthly payment.

Refund option:

A refund option can be selected that will pay a designated beneficiary all or a part of the remaining principal balance in installments over a specified period of time.

Tax Issues

Deferred annuities qualify under the Internal Revenue Code as retirement plans, and as such, they are afforded some of the same tax advantages as qualified plans such as IRAs.  Primarily, the funds that accumulate inside an annuity are not currently taxed.  They are taxed upon withdrawal as ordinary income. Contributions to deferred annuities are made with after-tax dollars unless the annuity resides inside of a qualified retirement plan.



Understanding Annuity Expenses

It’s no secret that annuities have expenses associated with them that aren’t found in other investments. In fact, annuity expenses are the favorite target for those who seem bent on criticizing annuities as investments.  Their usual form of attack is to try to frame annuities in the same investment category of other “equivalent” investment vehicles and then compare the expenses of each. The problem is that there is no direct equivalence when you consider that an annuity is actually an insurance contract that provides certain guarantees unlike any other investment.

Still, it is important to be aware of the expenses that are charged in an annuity contract because, ultimately, they do impact your return on investment.  By understanding annuity expenses, you will be in a position to weigh the long term benefits of annuities versus other vehicles.  The first thing to understand is that, as insurance contracts, annuities have a unique expense structure that is needed to support the guarantees and maintain their integrity as tax favored investments.

It’s also important to note that not all annuities are built the same. They come in different flavors so that they can serve different needs, so the expense structure will vary from one type of annuity to the next.  Generally, the more moving parts an annuity has, such as a variable annuity with its separate investment accounts, the more expenses it will have.  In general, depending on the type of annuity, an annuity investor can expect to pay somewhere between 1.5 and 3 percent of the account balance annually to cover all expenses.  Here is an overview of the expenses typically associated with annuity contracts:

Mortality and Expense Charges,

Also referred to as “insurance” expense, these fees cover the cost of the insuring the principal as a death benefit in a variable annuity. Additionally, the insurer uses these fees to cover its administrative and distribution costs. Any sales commissions and marketing costs are paid from these fees.  These charges range from 1 to 1.5 percent .

Fixed annuities generally don’t charge an annual fee for mortality and administrative expenses. Instead, their costs are covered in the spread between what they earn on their investment portfolio and what they actually credit the accumulation account.  In immediate annuities, these costs are factored into the annuity payout.

Investment Management Fees

Variable annuities include separate investment accounts that are managed by professional managers.  An annual fee is charged that is a percent of the account balances.  Some separate accounts, such as aggressive stock accounts, are actively managed and will charge a higher management fee than a less actively managed  account, such as conservative bond account.  Fees can range from just under 1 percent to as high as 2 percent.

Fixed and Immediate annuities have no separate investment accounts, therefore do not charge investment management fees.

Surrender Fees

Insurers will charge a surrender fee should an investor cancel the annuity contract before the end of a surrender period.  The insurer uses the surrender fee to offset the potential loss it could realize from its portfolio if it has to liquidate bonds at a loss to cover the surrendered funds.  It is also used as a deterrent to discourage investors from withdrawing their funds before the agreed upon timeframe.

These fees can range from 5% to as high as 10% of the surrendered funds, but most contracts have a declining fee schedule whereby the fee is reduced by 1 percent each year until it disappears.  Thus, in most contracts, there would be no surrender charge at the end of five to ten years.

Most contracts allow for annual withdrawals without a surrender charge if they are kept to 10% of the fund balance. Note: Withdrawals made prior to the age of 59 ½ may be subject to a 10% penalty by the IRS.

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Sales Loads

As with some classes of mutual funds, some variable annuity products include a front end sales load, or commission. In most contracts, the sales commission is paid to the salesperson by the insurance company rather than from the investor’s pocket.  This means that all deposited funds go to work for the investor and the insurance company will recover its commission cost from the annual fees.  No-load variable contracts, which are purchased direct from the annuity provider, are becoming much more prevalent.

Charges for Optional Features

Many annuity contracts offer optional features or riders that will enhance the product’s guarantees or protections.  These are added to the contract at the time of purchase, however, the charges are typically factored into the benefit itself.  For instance, is an inflation protection rider is added to an immediate annuity, the cost for providing that protection is covered by reducing the income payout by a certain percent.

Variable contracts that offer living benefit features, such a guaranteed minimum accumulation benefit (GMAB) will usually charge the separate account annually.

State Premium Taxes

Variable annuity investors should also be aware that their state may charge a “premium tax” on the amount invested.  This would be indicated in the prospectus which should be specific to the state in which you live.


There’s no getting around the fact that the expenses in annuities, especially of the variable kind, can add up, which is a key reason why they may not be appropriate for some investors.  Certainly, if you are in a high current tax bracket you can benefit from tax deferred accumulation.  And, if, for a part of your portfolio, you need more guarantees and protection, then annuities may make sense. In both cases, an annuity can provide superior benefits over the long term.  In any situation, it would be important to weight the long term benefits of an annuity against the costs, and shop rates, fees and expenses thoroughly.