Securing steady and reliable funding for retirement can be a significant challenge. While there are several paths to building your retirement funds, fixed annuity, and index annuity contracts provide an excellent approach to grow your retirement nest.
Both fixed annuities and index annuities may sound similar, but they work very differently. With fixed annuities, you’ll get a fixed return on your initial investment. An index annuity, however, offers higher returns in exchange for higher risks.
So which of these two types of annuities is best for your retirement fund? Let’s review both to find out.
How Annuities Work
An annuity contract is between you as an investor and a financial institution or insurance company. In an annuity agreement, you’ll provide money to the insurance company or financial institution. In exchange, they’ll promise to pay you a certain amount for a predetermined period.
You can fund an annuity with a single lump sum or make smaller payments over a period of time. This period where you’re contributing money to the annuity is known as the accumulation phase. The phase where you start to receive payments from the annuity is referred to as the distribution or payout phase.
All annuities have management fees and a surrender period when you can’t withdraw the funds invested without a penalty.
How Fixed Annuities Work
As the name suggests, fixed annuities have a fixed day of return on the money invested within the period of time. If you desire a guaranteed rate of returns, then a fixed annuity will be ideal for you.
A fixed annuity is similar to a bond and certificate of deposit (CD). You’ll know what the rate of returns will be before investing in the annuity. The insurance company will calculate the income payment based on the amount you invested as a lump sum or your total contribution within a period of time.
Why Invest in a Fixed Annuity
A fixed annuity offers an incredible way to preserve your savings and stretch it out over your retirement years. Some of its benefits include:
- Guaranteed rate of returns: The predetermined rate of returns means you’ll have little to worry about even if the market tumbles.
- Simple contract terms: Fixed annuity contracts are very straightforward and easy to understand.
- Improved budgeting: You’ll be able to plan your finances in retirement better since you already know how much you’ll be earning.
- Death benefits: Most fixed annuities have death benefit clauses that transfer the funds to a beneficiary if the investor dies before the funds are fully disbursed.
Fixed Annuity Disadvantages
- You’re locked into the same returns even if the stock market grows.
- Inflation can reduce the value of your money.
How an Index Annuity Works
The rate of return for an index annuity is based on specific market performance. Index annuities offer the potential to earn from the upside of the stock market. If the market performs well, you’ll earn more money. However, if the market declines, you will earn a fixed return rate or no loss to your investment.
Index Annuity Rates
The rate of index annuities is often capped. So if you have an index annuity with a participation rate of 80%, then your investment will only be eligible to earn up to 80% of the index annuity’s total returns. The participation rates of index annuities are often higher at the beginning and may decline in subsequent years.
A major positive with index annuities is that your losses are generally limited. For instance, if the stock market declines, you’ll earn a minimum guaranteed rate. The guaranteed minimum typically ranges from 1-3% annually.
Why Invest in an Index Annuity
- Stability: You’ll get a guaranteed minimum rate, which acts as a safety net.
- Higher returns: The potential for higher returns in high performing years.
- Security: Your principal investment is generally safe.
Index Annuity Disadvantages
- Caps limit fund growth.
- Early withdrawal fee up to 10%.
- Instability due to market fluctuations.
Which is Best: Indexed Annuity or Fixed Annuity?
To help you choose, here are some tips:
- If you’re a conservative investor who’s not willing to take further risk on your investment, then a fixed annuity will be best suited for you.
- If you’re an investor who likes to participate in the upside movement of the stock market, without having to risk your investment, then you should consider an index annuity.
- Another question that can dictate your choice is the purpose of the account.
Both annuities are suitable for retirement savings; they allow your account to grow tax-deferred.