Welcome to the Bowman financial strategies, retirement baits, simple series. Your host is Erik Bowman, retirement income certified professional and certificate holder of the national social security association.

Hi everyone. My name is Erik Bowman and we are going to be discussing what is a fixed indexed annuity. So, starting from the top, we need to understand what an annuity is. And an annuity is a contract between the annuitant, the contract holder and owner and insurance company. So, let's talk about the two primary uses of fixed indexed annuities. 

The first one is income. That means we're going to be putting cash into the annuity. And one day flipping a switch and turning on a lifetime income stream of some sort. But one of the primary ways that we utilize fixed indexed annuities is for what we call protected growth. So, we're seeking potential growth of our cash inside of the annuity. However, we want to maintain principle protection. 

One way to think about a fixed indexed annuity is really to picture a box and inside of this box there's going to be investment options that are available to you. We're going to have access to specific indexes and our rate of return will be based on the performance of those indexes. The way they calculate your rate of return on those indexes is by something called the crediting rate.

A segment is a defined period of time. Oftentimes one, two or three years in length where you're measuring the return of the index that you're investing in. The lock-in is the amount or the accumulated amount of the annuity that's going to be preserved or locked in at the end of a segment. The contract length is the full duration of the annuity. Typically, they range from anywhere from three to 10 years and anywhere in between, for example, you could have a seven-year contract with seven, one-year segments.

Participation rate is the percentage of the index return that you're going to get. If you have, for example, an 80% participation, or we call it par rate; if the index were to increase by 10% and you have 80% participation, 80% of 10% is eight. So, you would be credited with 8%. 

The spread is another important term, and it starts to sound pretty complex when we start talking about terms you might not have heard before. But think about the spread as a hurdle. It's a percentage that you have to get past and then you're going to have rate of return in, on everything in excess of that spread. So, in this example, we have a 2% spread. If the index were to get a 10% rate of return, you would get an 8% rate of return because in this case, you've got the return over the spread.

A cap is the maximum amount of return you can get inside of an index over a segment. So, let's take an example of an index with an 8% cap. If the index itself achieved 9%, you would get 8% because that's the highest level you can get. Likewise, if the index got eight, you would get eight. 

Let's go through an example of a fixed indexed annuity and how the interest rate is credited using a nine-year contract with three, three-year segments. So first you can see we've invested $100,000 in the first three-year segment. We see that the index we're invested in, goes up, it goes down and it ends a little bit higher. So, let's say over that three-year period, the index ended up 12% higher, but you had a 75% participation rate in that gain. In that case, you're going to receive a 9% rate of return, that 9% on top of a hundred thousand brings your principle value to $109,000. And because it's the end of the first segment that is now locked in, and it's your new low watermark for your principle in that annuity. 

Now in the second three-year segment, we see that the index is moving up and down, but at the end of the third year of the second segment let's assume that there was a minus 5% rate of return on that index. Wilson's fixed index annuities have a 0% guaranteed rate of return on the lowest end. You're going to exhibit no loss on the principle value. And so therefore your principal value of 109 is preserved and then going forward into segment three, you're going to invest in an index and you'll have some level of participation. And in this case, let's assume that we had 75% par on a 12% rate of return over the duration of the segment, you got another 9%. So now your total principal value at the end of the ninth year as $118,810

Fixed index annuities are like anything else in the world. They have their ups and they have their downs. First, fixed index annuities as we spoke about have principle protection, regardless of index performance, you're going to still have your principal preserved. In addition, the fixed index annuities are going to have growth potential based on the crediting methods that we just talked about. 

There are some annuities that offer what's called an optional lock-in. So, an optional lock-in says, if I'm happy with the principal value and the growth that it's achieved so far, you might be able to voluntarily lock it in at that value. And that will be your new low water Mark or floor. Another pro of fixed index annuity, that is significantly different than variable annuities is there is no fee unless you're choosing a rider or a specific type of investment. Most of the fixed indexed annuities, and certainly the ones we use, primarily have no fee associated with them.

Now on the downside, there are some limited liquidity provisions, but if you took all of your money out in year two, you may pay a pretty hefty contingent withdrawal charge to the insurance manufacturer. The contingent withdrawal schedule usually starts off with a higher charge earlier in the contract and a smaller charge later in the contract. In addition, you don't get dividends and interest. You're not actually investing inside of the underlying holdings and therefore you do not get dividends and interest. And finally, there is potential for opportunity costs. And what we mean by that is fixed indexed annuities are typically not going to have the same type of positive rate of return during an upmarket, as a straightforward investment into a stock index, for example, where you get dividends and interest, and that rate of return. 

 However, we can't predict the future and we don't know what those indexes are going to do. So, for a portion of assets, we many times would recommend that a portion be protected from potential market loss. 

If what you've heard today has prompted you to want to learn more about retirement planning concepts or more about your personal situation. Click on the calendar link to schedule time on my personal calendar, where we can talk about how you can receive your customized tax preparedness and retirement report.

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