7% For 7 Years: S&P Upside, Zero Downside: Fixed Indexed Annuities Explained

Buying the S&P 500 upside with full downside protection via a 7% to 9% fixed indexed annuity (FIA). Learn how FIAs work, the advantages & disadvantages and who might consider buying one.

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(Cont.) 7% For 7 Years: S&P Upside, Zero Downside: Fixed Indexed Annuities Explained

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Buying the SP 500 upside with full downside protection. 7 to 9% upside on a fixed index annuity. Let's see how much you could earn right now. Hello, Diamond Esteec Members, Super Savers and Course fans. I hope you're healthy and well. At the time of this taping, both the SP 500 and the NASDAQ indices have still not come down all that much from their recent all-time highs, despite the ongoing market and geopolitical uncertainty, as well as concerns about AI and a stock market bubble. So it's no wonder that many of you are once again asking: is there a way for you to lock in the current index levels while at the same time still keeping a foot in the market in order to participate in any additional upside that may potentially come in the future? And this is a tricky question. There are some structured protection ETFs out there that can do that by giving you more or less downside protection for, say, a year, while still letting you participate in the upside of a chosen equity index up to a predefined cap. And we will be discussing these in detail in the coming weeks and months. But what if you want to lock in the downside protection as well as the upside participation cap for longer than 12 months? Well, that's what we'll be talking about today. Fixed indexed annuities or fias, because fias are offering some quite attractive rates and caps currently, and we want to make sure you fully understand them before adding one to your portfolio. So with that in mind, here are the three topics we'll be covering today. One, what is a fixed indexed annuity or FIA? How does it work? And what are the key advantages and disadvantages? Two, what are some FIA examples based on current conditions in the market? And in this section, we'll walk you through the rates you might be able to get right now with some of the highest rated insurance companies. And three, who should and who should not buy a FIA? Let's dive in now, folks. What is a fixed indexed annuity or FIA? How does it work? And what are the key advantages and disadvantages? Fixed indexed annuities, FIAs are essentially insurance products that are locked in for a certain period, a certain term, as the industry says. For example, three, five, or seven years. And the somewhat unwieldy name already hints at their hybrid nature. Because what FIAs fixed index annuities really do is that they combine two products into one, if you want. The fixed in the name stands for the fixed interest that fias can offer on the part that behaves more like a traditional fixed annuity. It functions almost like a savings account with the fixed interest rate resetting every 12 months. The indexed in the name refers to the other part of the fiat that is linked to an index like the SP 500. And this index part is what offers principal protection with the option for some potential market-based upside on an index. So this fixed bucket and this indexed bucket, let's take it step by step. When you buy a fiat, you decide how much of your capital you want to allocate into each bucket. The fixed bucket is really nothing special if you want. It pays you a fixed interest rate, as we just mentioned, and the rate for the first year is set at the time of purchase, based on market conditions at that point in time. Let's say it's 4.15%. Just for illustration purposes, and to make it easier to follow the examples that we will be walking through shortly. Keep in mind that your personal rate may or may not be this 4.15% or any other number that we'll use in our illustrations, depending on when you're watching this video, and will only be set when you actually sign your fixed index annuity contract. But back to our example. Once you pay in your capital, this fixed bucket of your fiat basically behaves like a savings account, as we touched upon earlier. At the end of every year, your fixed bucket gets credited with the interest, which then accrues to the principal. The increased principal then starts earning interest in turn for the following year at a rate that is updated annually according to market conditions. There are no regular interest payouts during the term of the fiat, which also means that your capital grows tax deferred. The index bucket is more exciting, so to speak, because that's where you get the capital protection and the additional upside on an index, as we said before. But it takes a few steps. First, you decide on the index that you want to use as a benchmark. The SP 500 seems to be the most popular choice, but there are other options as well, depending on the insurance company, such as indices based on mixed stock bond portfolios, US real estate, US retiree spending, or even gold shares. Second, the insurance company credits this index bucket with your capital. However, the amount is not used to buy any underlying securities directly. There is no separate account or depot that you own. Just like for the fixed part, you have to trust the insurance company to pay everything that they owe you when it comes due. You carry the counterparty risk, as the industry says. This is why it's so important to choose an insurance company with strong ratings. Third, when you choose an index, you also define how you will participate in any future upside of that index. You often have no choice here. Most investment options come with a limit that is predefined by the insurance company. This can be a percentage cap on the upside. For example, the performance of the SP 500 up to a cap of 9%. It can also be a certain participation rate or percentage of the gains without a cap. For example, 70% of the increase in the US retiree spending index. Fourth, the caps on the upside and the participation rates are usually set for one year. The industry sometimes calls this point-to-point, which means they really only look at the first and the last day of the 12-month period, but do not calculate current values in between. After every year, the caps on the upside and or participation rates then reset for the following 12 months based on market conditions. As I mentioned at the beginning, you sometimes have the option to lock in the upside cap and or participation rates for the entire term of the fiat, most notably for the SP 500. But this is not available with all insurance companies, and it usually comes at a price. For instance, the initial 9% upside cap for the SP 500 that I mentioned before as an example would be valid for the first year, but then recalculated every 12 months according to market conditions. If you want an upside cap on the SP 500 that would remain valid for the entire 7 years of a FIA contract, it would usually be set a bit lower. For example, at 7%. Fifth, regardless of which index you choose, your principal is guaranteed. In other words, the minimum return for every single year will be 0%, so never negative. And it's not just your initial investment that's guaranteed, but all the accrued earnings as well, once they're credited to your account. Do note, however, that the SP 500 used here is a price index and does not take dividends into account. Here are three points about how you can manage a fiat over its lifetime. Point number one, whenever the caps or participation rates reset, you can usually reallocate, move your capital between the fixed and the index part of the FIA, or change the index you're following in the index bucket, depending on your market outlook and personal strategy. In most cases, this option exists every 12 months. The one big exception is when you lock in a participation rate or an upside cap, such as for the SP 500's performance for a longer period, like the seven years I mentioned before. In such a case, you can't really shift money between buckets during these seven years, but have to wait for the next rate reset, which generally means at the end of your fiat term. So let's try to bring together what we've been discussing so far. With some sample rates for three fias with different terms or maturities from an A double plus rated insurance company that our trusted annuity specialist works with. In this column, we have the fiat term or maturity. In this column, we have the first year interest rate for the fixed bucket. And in this column, we have the first year percentage cap on the upside for the index bucket where only the first year is fixed, using the SP 500 as the benchmark. And in this column, we have the annual percentage cap on the upside for the index bucket where it's locked in for the entire term of the annuity. Again, using the SP 500 as the benchmark. And in this last column, we have the minimum investment amount required to get these numbers here. Remember though that these rates are illustrative only and that rates change all the time. Your personal rates and caps will only be locked in when you sign your fiat contract. That said, in case you're interested in exploring potential rates for your personal situation, email us at jennifer at diamondestic.com so that we can connect you with our trusted annuity specialist who can help pull together the latest numbers for your individual circumstances, goals, and expectations. So for example, if you were to purchase a$100,000 seven-year fiat at the time of this taping from this carrier and you allocated the full$100,000 to the fixed bucket, your rate might be 4.15% for the first year. But for the second year and every year thereafter for the entire remaining seven-year term of the fiat, this 4.15% in the fixed bucket will be recalculated and may change based on the then existing market conditions. If you allocated the full$100,000 to this index bucket one, where the percentage cap on the upside is fixed for the first year, but resets every year thereafter, you might be able to participate in the upside of the SP 500's performance up to the cap of 9% in the first year. But in the second year, all the way up to the last year of your fiat term, this 9% cap rate on the upside in index bucket 1 will be recalculated and may change based on the then existing market conditions. If you allocated the full$100,000 to this index bucket two, where the cap rate is locked in for the entire term of the fiat, you might be able to participate in the SP 500's upside performance every year up to the cap of 7% for the entire seven-year term of this fiat. In other words, this 7% cap rate on the upside in index bucket 2 stays the same every year for the entire 7-year fiat term. And to say it once more, in all the buckets for this fiat, your principal as well as all earnings that have already been credited to your account are fully principal protected, meaning that your yearly return will never be negative and will never go below 0%. And as I touched upon earlier, if your fiar works like an index bucket one, you can reallocate your capital between this index bucket one and this fixed bucket every year. If your fiar works like an index bucket two, you typically will not be able to reallocate your investment amount until the end of the fiat term, which in the example we just went through is seven years. We will show you a few detailed examples with numbers for every year in the second part of today's video to make this even easier to understand. For now, let's go back to these sample rates. As with most types of annuities, fiat rates and caps are primarily driven by interest rates, meaning that they are still at very attractive levels at the time of this taping and could start to come down with the market anytime. That said, your fiat rates and caps may vary depending on your investment amount, annuity term, the insurance company's credit rating, your state of residence, and so on, as I said before. As you can see here, the longer the term, the higher the rates and caps on this table. And if you were to buy a three-year fiat from this insurance company, this blacked-out box indicates that you wouldn't even have the index bucket to option to lock in the percentage cap on the upside of the SP 500's performance for the full three-year term of the FIA. Meaning that for this three-year fiat, this 3.35% on your fixed bucket, and this 5.5% first year cap on the upside of the SP 500's performance, both these numbers have the potential to change after year one. Now, let's move on to point number two on how you can manage a fiat over its lifetime. At the end of the FIA term, or at maturity, as we would normally say for bonds. So at the end of the fiat term, a fiat, like some annuities, offers several payout methods. You can take everything as a lump sum payment, but you can also roll the entire capital over tax-free into a new annuity or opt for a lifelong monthly income stream, just to name some popular options. However, liquidity before the end of the fiat term is limited. There are no regular payouts, and penalty-free early withdrawals are usually restricted, often to 10% of the account value per year. And when you withdraw, you lose all interest that has accrued in that year but has not yet been credited to your account. If you need more than the penalty-free early withdrawals, it is possible to cash out, but you may be subject to surrender charges, for example, of up to 9% in the first year, depending on your contract terms. That said, surrender charges usually decrease over time. And point number three on how you can manage a fiat over its lifetime. Because fias, like all annuities, are insurance products, you may be able to add on certain insurance features to them. The industry calls these add-ons riders. Depending on the product and provider, these might include death benefit riders, cost of living adjustment riders, or long-term care insurance riders. One rider that is particularly popular for fias is an income rider, sometimes also known as a guaranteed lifetime withdrawal benefit, GLWB, or guaranteed minimum income benefit, GMIB. An income rider comes in an extra cost, but it allows you to lock in a guaranteed framework andor minimum for future lifelong income. Basically, if you want, you know already when you buy the annuity that you will have a predefined framework andor minimum for an income stream from a certain age for the rest of your life. An income rider can only be bought at the same time as when you buy your fiat. There's no option to add it onto your fiat later on. The income rider also costs extra, often 1% to 1.25% of your annuity per year. That said, it may be worth it if you strongly believe that rates may come down substantially before you start taking your income. Or if the thought of having already secured the framework andor minimum for a lifelong future income stream is what lets you sleep well at night. Compare this to what happens when you buy a FIA without an income rider. In this case, you'll have a certain amount of money in your account at the end of the term. You know it won't be less than the guaranteed amount, but you don't know exactly how much it will be, as this will depend on the development in the markets. You also know that you'll have some flexibility. For example, you can take the entire amount as a lump sum. You can roll the amount over into a new annuity, and of course, you can still buy a lifelong guaranteed income at that point by converting your capital into a SPIA, a single premium immediate annuity that starts paying out immediately. However, how much in guaranteed lifelong income you will get at this point when you buy the SPIA will depend, among other factors, on how much your FIA value will be at the end of the term and where interest rates will be. So the lifelong payments from the SPIA could be more, less, or the same as under an income rider. You just don't know. So now that you know how the fixed indexed annuity got its somewhat confusing name and how it works in principle, let's summarize the five key points that speak for or against buying a FIA. Here are the five key advantages of buying a fixed indexed annuity. One, the index bucket of a FIA allows you to participate in any future gains of the market by choosing an index, even if your upside will be less than if you had invested in the same index directly. Remember, a FIA will either have a certain percentage cap on your upside or it will only allow you to participate in the upside to a certain degree. That's the price you pay for the downside protection. Which brings us to two. Your principal is guaranteed with a FIA. You will never see a negative return, regardless of where markets go. 3. AFIA allows you to get as much certainty as possible about your future lifetime income streams if you choose to add an income rider to it at the time of purchase. Remember, you must buy the income rider at the same time that you buy the FIA, and it gets a yearly fee, it will guarantee you a framework andor minimum amount for an income stream from a certain age for the rest of your life. That said, this option might take away some of your flexibility at the end of the term. Which brings us to four. A FIA gives you several options to choose from at the end of the term based on your circumstances and market conditions at that point in time. You can take a one-off lump sum, roll the amount over into a new annuity, or convert it into a guaranteed lifetime income stream. Five, fias offer tax-deferred growth, and at the end of the term, as we just mentioned, you can often roll them into a new annuity tax-free via 1035 exchange if certain conditions are met. That said, if you elect to take a lump sum payout at the end of the term, it may generally be taxable as ordinary income. Now, let's move on to the five disadvantages of a fixed indexed annuity. One, and probably the biggest disadvantage of a FIA and of annuities in general is that they are pretty much illiquid before their term ends. Some annuities offer penalty-free withdrawals, often 10% of the value per year. But if you exceed that allowance, you'll have to pay a penalty that is often not insignificant. And as I touched upon earlier, interest that has been earned but not yet credited to the account is usually lost when you withdraw during the year. So when you see annuities with attractive rates in the market, remember that any return advantage over competing products may in part be driven by an illiquidity premium. Two, and this is related to the first point. A FIA will not distribute any interest or dividends at all during the term of the contract, during the initial accumulation or savings and growth phase. Payments from a FIA generally begin only at the end of the term. 3. The upside of a FIA is always capped or otherwise limited for the indexed bucket. This is the price you pay for the downside protection, as we've already talked about extensively earlier. Four, you don't have any ownership of the underlying assets with a FIA, but rather you have to rely on the credibility and financial strength of the insurance company and as a backup on the insurance guarantee association of your state. So always make sure you work with a financially sound and well-rated insurance company. Five, fias can be complex, as I'm sure you're already seeing. Now, I hope this video has helped you understand them a little bit better. But they are not simple products. That said, if you think these fiat advantages here may outweigh the disadvantages and want to see how attractive rates may be when you're watching this video, shoot us an email at jenniferdiamonestic.com so that we can connect you with our trusted annuity specialist who can simplify the process and create a customized plan for you. Now, let's take a look at a FIA example under three different scenarios, which may make it all a bit less abstract. What are some FIA examples based on current conditions in the market? Before we start, let me remind you that all the numbers we're using in this video are based on current conditions in the market at the time of this taping. But they are not guaranteed and should be considered for illustration purposes only. Your personal rate will only be set when you actually sign your fiat contract. And please do note that we use our standard, no default scenario with regards to the counterparty risk you carry, which is a fancy or technical way of saying we assume that the insurance company that you buy the annuity from will not default. And let's use these basic assumptions for all three of the FIA illustrations we're about to walk through. One, you're buying a$120,000 FIA with a term of seven years. Two, of this$120,000 You will invest$100,000 into an index strategy based on the SP$500 with a capital guarantee, meaning a minimum return of 0% and a cap of 7%, meaning you will get credit for an increase in the SP 500 of up to 7%, but not beyond. We also assume that this 7% cap is fixed for the entire 7-year term of the fiat, meaning that if we go back to our sample rates overview from earlier, we are basing our illustrations on index bucket 2. But remember that most fias may also give you the option to start with a potentially higher cap, like in index bucket one here. But this higher cap rate gets reset every year according to market conditions. We will not be modeling out illustrations for index bucket one because, well, we can't predict where rates will be after year one. Assumption three: you will invest the remaining$20,000 into a fixed strategy with a guaranteed interest rate of 4.15% for the first year. So again, that's this 4.15% from the fixed bucket in our sample rate slide from earlier. And also as discussed earlier, this 4.15% on the fixed bucket will reset every year. So in years two to seven, we have assumed an interest rate of 3% for the fixed strategy for the sake of simplicity. 3% is roughly the rate the members of the Federal Reserve Open Market Committee, the FOMC, currently project for the long run. As we always say, no one can predict the future, not even the FOMC members. So who knows where rates will actually go? But 3% is the best assumption that we could find. Now, because a big part of the charm of a FIA is the capital protection, let's look at the worst case scenario first. What happens to your money when you put in your$120,000 now and then your fears come true? And the SP 500 shows continuous losses for the next seven years? And the short answer is not much happens, and you might even feel a bit smug about locking in the SP close to the peak. While markets may be collapsing around you, the principal protection of the FIA kicks in. And your capital is preserved in the index bucket. The initial amount of$100,000 that you put into it in year zero stays at$100,000 at the end of year seven. And in the fixed bucket, you even earn a bit on top. The initial amount of$20,000 that you put into it in year zero grows to$24,872 by the end of year seven, giving you a total amount of nearly$125,000 from both the fixed and the index buckets at the end of your seven-year fiat term from your initial investment of$120,000. For an overall compound return of 0.57% per year, which does not sound great, but remember that we're talking about the worst case scenario here. And under such a scenario, the FIA has served its core purpose: capital preservation, downside protection, even with a small bit of growth. Now, one could argue that the interest we assume is a bit too optimistic. If markets were really this bad over a seven-year period, chances are the economy would be in the doldrums and rates would go lower than the 3% that we assumed in years two to seven for the fixed bucket. That said, and as far as we can remember, and Marcus and I have pretty good memories, at least for now, the SP 500 has not seen such a bad patch of negative returns over such an extended period of consecutive years yet. The worst stretch seems to have been four consecutive negative years during the Great Depression. But yes, in the very, very worst case, at the end of the term, you would only get back your principal plus the interest on the fixed bucket in the first year. Now, let's take a look at the other end of the spectrum, the best case scenario. FIAs generally cap the upside on the SP 500 at a certain level. So there is a maximum return that you can get. This is different from a direct investment in an SP 500 index fund, for example, where the gains are unlimited, but the losses can wipe out your entire investment, at least in principle. So, in the best case scenario, we assume that the SP 500 grows by 7% or more every year over the term of the contract, which means that you'll get credit for the maximum possible 7% every year under the cap. As a result, your index strategy grows from the initial amount of$100,000 that you put into it in year zero to$160,578 over seven years. The fixed strategy behaves exactly the same as in our worst case scenario. In reality, it may even perform a bit better if we assume that the economy is booming and that the Fed keeps raising rates, which might then push up your interest at every reset. We did not model such a scenario out though and stuck with our 4.15% for the first year and 3% for the years two to seven. Overall, this gives you a total amount of just approximately$185,000 from both the fixed and the index buckets at the end of your seven-year fiat term. From your initial investment of$120,000, which translates into an overall compound return of 6.42% per year over the seven years, which isn't bad when you consider the capital preservation element of your fiat. Of course, you would likely have done better with a direct investment in the SP 500 during those years of strong growth. But as I said before, that's the price you pay for the downside protection. On to our third scenario now, where we assume a wild swing in the market. The first four years being boom years that get you to the maximum 7% cap on the index strategy, followed by three years of bust, where markets go into negative territory and your principal protection kicks in. And we'll call it our first boom, then bust scenario. And what we see here is that your overall portfolio grows nicely at first, from an initial$120,000 to$153,841 at the end of year four. However, then the markets collapse, so to speak. The good news here is that the principal guarantee kicks in and applies the full amount in the index bucket that has already been credited to your account, including past gains, and you keep the entire$131,080 that you've earned so far. For the fixed bucket, we work with the same assumption that we used in the previous scenarios, and it keeps growing through both boom and bust. Overall, this gives you a total amount of nearly$156,000 from both the fixed and the index buckets at the end of your seven-year fiat term. From your initial investment of$120,000, which translates into an overall compound return of 3.81% per year over the seven years. This might even be a decent return depending on the severity of the hypothetical downturn during the last three years. And one more important comment on the fixed strategy or bucket. It does add a bit of return over the bad years, but given that the index strategy has a principal guarantee anyway, it may not really be needed to stabilize your portfolio. So it's no surprise that many buyers of fias put the overwhelming part of their capital, or even all of it, into an index strategy. This gives them the maximum possible upside while they still know that the principle is guaranteed, even in a bear market. In other words, you probably wouldn't buy a fiat for the fixed part, but for the index part. What many, if not most folks who purchase fias want is participation in the potential growth of the equity market, even if that upside is cap, but with a bond-like principal guarantee. So far, so good. I hope our best case, worst case, and first boom and then bust scenarios make fixed index annuities a bit more concrete and help explain why some folks find them attractive at these current levels. At this point, you might be pondering could a FIA potentially be something for you? This will, as in all things that have to do with money and investing, depend on your personal circumstances, goals, and expectations. And it brings us nicely to the next section for today. Who should and who should not buy a FIA? Here's our personal perspective on who might benefit the most from a FIA. One, you value long-term stability, safety, and predictability. These are qualities at which fias and other annuities tend to shine in comparison. Two, you want to participate in the upside of a specific market index. We use the SP 500 as our benchmark index in today's illustrations, but there are a number of other ones you may be able to choose from depending on which insurance company you purchase your fiat from. Three, but you also want to know that your principal is protected. Or in other words, you want equity like market upside without the equity like market downside, even if that means that your upside is capped. Four, you want competitive rates, potentially at the upper end of the range, and are comfortable locking your money up for several years to get these rates. Five, you trust the financial strength and ratings of the insurance company that you will buy the annuity from. State insurance guarantee associations will provide a safety net within some limits, but better if you don't have to rely on it. If you tick all five of these boxes like the vast majority of fias folks in our Diamond Neste community do, then fias may be something to consider exploring further. Of course, that also means that fias may not be the right choice for you if you disagree with even one or two of these points. For example, if you're nowhere near retirement and or if you're in the accumulation phase and are more concerned with building and growing your portfolio than with stability and predictability, fias may not fit the bill perfectly. Features like the principal guarantee cost money and may take away from long-term growth. In such an instance, it may make more sense to invest directly in the market via low-cost equity funds for the growth part of your portfolio where your upside is not capped. And for the more conservative part of your portfolio, you could focus on treasuries, agencies, and other types of bonds, or even other types of annuities like the multi-year guaranteed annuities or migas that we talked about in this video here, which function more like tax-deferred CDs, offering principal protection and steady growth. Regardless of whether we're talking about migas, fias, or any other type of annuities, annuity rates and caps in general continue to be at quite attractive levels that have not been seen in over a decade. And the right annuity has a lot to offer the right individual. But finding the right annuity is not something you should have to do alone, given how complex annuities can get. So shoot us an email at jennifer at diamondnestic.com so that we can connect you with our trusted annuity specialist to explore the rates and different types of annuities that you might be able to get currently. Because as I'm fond of saying, everyone's financial journey is different. And there's no cookie cutter, one size fits all annuity solution. Any annuity you purchase should be customized to your individual circumstances, goals, and expectations and fit properly in your overall portfolio, regardless of size. Alright, Diamond Stec members, Super Savers and Boncourse fans. I hope you enjoyed today's video and learned something new and see you very soon with more brand new, wealthy loving content for your financial journey.