The financial meltdown of 2008 launched a flight to safety that saw billions of dollars move from plummeting mutual funds into safe, fixed yield investments such as CD’s and annuities. Investors who saw their 401(k) plans cut in half in just a few months quickly turned to wealth preservation vehicles in order to protect their dwindling assets. Many of these investors discovering wealth protection virtues of annuities for the first time found themselves faced with two different types of fixed yield annuities and quickly had to learn the differences between fixed vs indexed annuities.

What’s to Compare?

Fixed and indexed annuities have more similarities than differences. They both credit a fixed yield to the annuity accounts. They both guarantee a minimum rate of return. They both allow interest earnings to accumulate tax deferred. They both allow investors access to funds through a withdrawal provision. They both offer a death benefit guarantee, and they are both convertible into an income annuity that guarantees a lifetime of income.

There is one primary difference, but it is significant, and that is how the fixed yield is determined. While the yields are fixed for both, a fixed annuity credits a yield that is generated from the investment performance of the life insurer’s general account, and the yield of an indexed annuity is generated from the percentage gain of a stock index. Because life insurer’s general account is invested interest bearing bonds, the resulting yield more closely mirrors those that are available in other fixed yield instruments such as CDs. Since the yield of an indexed annuity is derived from a stock index, it has the potential of exceeding the yield of fixed annuities.

Fixed Annuity Yields

The rates on fixed annuities are generated from the overall yield that life insurers earn on their own investment portfolio which consists of high quality corporate and government bonds of varying maturities. The rate is guaranteed for a specific length of time, from one to ten years, after which it is adjusted based on prevailing rates. But the new rate can never be adjusted lower than the minimum rate guaranteed in the contract. Because of this, fixed annuities provide the ultimate in predictability along with the assurance that the principal is secure.

Indexed Annuity Yields

The higher yield potential of indexed annuities brings with it an added layer of complexity due to the mechanisms employed to generate the yield. As previously indicated, indexed annuity yields are derived from the percentage gains of a stock index such as the S & P 500. If the index experiences a gain from one year to the next, the annuity account is credited with a portion of the gain. The other portion is retained by the life insurer as a “premium” for providing downside protection, because, even if the index experiences a decline, the annuity account is still credited with a minimum rate of return.

The mechanics of determining the indexed annuity yield are a little more involved. First, a participation rate is applied to the gain to determine the gross yield to be credited. For example, a participation rate of 80% applied to a 20% gain in the index would mean that 16% would be credited to the account. But, that is before the rate cap is applied. Each contract specifies a maximum rate that can be credited, so if the rate is capped at 8%, then, using the same example, 8% is credited to the account instead of 16%. Essentially, the market protection provided by the life insurer cost, in this case, 12% of the gain, which may seem like a hefty price, except to those investors who have incurred the wrath of major market declines.

Participation rates and rate caps vary widely from one product to the next, so it would be important to compare them to see which product can generate optimal yields from gains in the stock index. Just as fixed annuities offer a rate guarantee for a specific period of time, indexed annuities offer a guaranteed participation rate for a period of time. A high participation rate may turn out to be a way to lure you in, only to have it drop significantly in a subsequent year.
Indexed annuities provide an extra layer of protection by ratcheting up the principal, or basis, each year to include the prior year’s gain. This annual reset ensures that the annuity account will never lose value.

Another key difference is in the surrender provisions. Both types of annuities allow for one annual withdrawal during the surrender period that does not exceed 10% of the annuity balance. Excess withdrawals are charged a surrender fee which can be high in the beginning of the contract and then gradually declines to zero over the surrender period. Indexed annuities tend to have longer surrender periods (up to 15 years) and higher initial surrender fees (up to 15%). Again, it may be considered the high cost of downside market protection provided by the life insurer.

A Little Education can Yield Higher Returns

From an investor’s perspective, fixed and indexed annuities both offer a high degree of safety and predictability. While indexed annuities have the potential of generating higher yields than fixed annuities, their complexity may be too much for some people. Some investors who are risk adverse are also adverse to complicated investment products, so even the prospect of earning a few more percentage points on their yield, may not seem worth the trouble of understanding how indexed annuities work. But, for those who are willing to understand the mechanics of indexed annuity yields, those additional percentage points of yield can make a significant difference in long term accumulation.

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