Annuities can help solve the biggest challenge of retirement.
When you save up for retirement, the two largest risks are intertwined. First, you risk not being able to pay your bills if you don't properly calculate your annual spending. Second, you risk running out of money late in life if you don't properly anticipate your lifespan.
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To help address these issues in tandem, insurance companies sell a product called fixed-index annuities or FIAs. These are designed to provide a baseline of growth-oriented income for the rest of your life. But, as Morningstar researchers recently pointed out, FIAs only work if you use them properly. Otherwise, they turn into money losers compared with more standard options such as fixed-income annuities or index fund portfolios.
What Is a Fixed-Index Annuity?
A fixed-index annuity is a contract you make with an insurance company. In exchange for money upfront the company will give you structured payments over time. Some contracts specify a duration for these payments, making them each month for 10 or 20 years, for example. More often people buy retirement assets called "lifetime annuities," which start payments when you retire and continue for the rest of your life.
Fixed-income annuities make this payment based on a guarantee. When you buy the contract, the company agrees up front to a certain monthly payment. For example, you might buy a contract for $2,500 per month for the rest of your life beginning in retirement.
A fixed-index annuity is less determined. These contracts guarantee payment, but the amount is not static. Instead, the payments are based on the performance of an underlying index such as the S&P 500 or the Russell 2000. You cannot lose the underlying principal in your contract, and most will come with a guaranteed minimum monthly payment. Otherwise, your income from a fixed-index annuity will increase or decrease based on the performance of its index.
This makes fixed-index annuities a risk/reward tradeoff. If the index does well, this product can pay significantly more than fixed-income annuities, and can even act as a hedge against inflation. If the underlying index does poorly, however, you can potentially make much less money in the long run. This risk is significantly mitigated if you invest in a mainstream index like the S&P 500, but is not trivial if you invest in a higher-risk field.
The Key To Fixed-Index Annuities Is Proper Use
Risk and reward is a very delicate balance in retirement. On the one hand, you want your money to keep growing during these years. On the other hand, you don't have new income to replace losses, so you want your money to remain safe.
Recently, Morningstar examined where fixed-index annuities fall in that balance. They compared the overall performance of an FIA with a guaranteed lifetime withdrawal benefit rider (GLWB) against standard fixed-income annuities and portfolio investments.
"Overall," wrote analyst Spencer Look, "I found that FIAs with a GLWB improve projected retirement outcomes, but only if they are used properly." Specifically, this product can result in stronger payments, fewer shortfalls and more money left over in your estate for the right investor.
But what constitutes proper use? Morningstar found two critical elements:
1. Early Investment
More than anything else, Look found that investors need to buy their FIA at least 10 years before they begin to make withdrawals. For a typical retiree, this means investing by or before age 55.
Why? The annuity needs time to grow. The more time the index has for cumulative growth, the more it will pay. Investors who need income more quickly than this typically see better results with single premium immediate annuities, meaning a fixed-income annuity that you purchase with a lump-sum upfront.
2. Lifetime Investment
This asset also is best for retirees who will hold it throughout their lives.
Exiting an annuity early is known as "lapsing." When that happens, you collect back the money you put in (often minus a penalty fee) and the contract stops making payments.
Much of the reason to buy this product is that it makes payments for the rest of your life. Over those years and decades, Morningstar found that you will often make more money with an FIA than if you had invested in a fixed-income annuity or a simple stock portfolio.
But if you exit early, you miss out on those future gains. In this case, you often make less money overall than if you had invested in a lump-sum annuity or a stock portfolio.
Longevity Risk Protection
In particular, Morningstar found that a fixed-index annuity can help protect people from running out of money in retirement. "This is because," wrote Look in his analysis, "an FIA with a GLWB is an insurance product that mitigates against market risk and longevity risk."
Retirement savers who put their money into portfolios, such as stocks, bonds or index funds, can often get stronger growth than with more careful products like an annuity. But that money is finite, so they risk running out of it.
A fixed-index annuity offers a best-of-both-worlds approach. While FIAs don't give the full return of their underlying index, they do tend to post stronger returns than a standard fixed-income annuity. Yet, they also come with lifetime payments and a minimum benefit guarantee, mitigating the risk of running out of cash in old age.
Based on Morningstar's analysis, investors who are looking for a lifetime retirement product should consider fixed-index annuities. They can offer a strong middle ground between the lower-return/higher-security of a fixed-income annuity and the higher-return/lower-security of a portfolio, but only if you use them correctly. Exiting the contract early can decrease or eliminate the benefits altogether.
Annuity Investing Tips
Annuities can be a strong product for the right investor, but they can often seem complicated. Don't sweat it. With our step-by-step guide, you can learn the fundamentals of annuities so you can feel more confident about these financial products.
A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn't have to be hard. SmartAsset's free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now.
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