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Want to lock in your retirement gains? It's a key role of fixed index annuities

by Jason Van Steewyk | Contributor
June 8, 2020

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The market is dangerous. It's prone to big swings in both directions. A bear market at the wrong time can devastate your retirement income potential. In this article, we explain the reality of stock market risk. Then we discuss how you can protect your retirement income against market losses — and still participate when the stock market does well.

On Feb. 12, 2020, the stock market set an all-time high of 29,551. That had people feeling very good about their portfolios. But smart consumers always know the party can end at any time. After all, the market is at its most dangerous precisely when it's at its highest.

Markets have crashed many times before, and the latest market nosedive happened just a few weeks after hitting its peak, ending the longest bull run in market history as the COVID-19 pandemic took hold.

As recently as 2018, the S&P 500 dropped 19.8% off its high. That was scary for people who didn't protect themselves. Fortunately, it recovered quickly that time. But it's not always so.

"The fastest way to wreck a retirement portfolio is to be forced to sell shares in a bear market for income."

A bear market is defined as a market decline of 20% or more. Since 1929, U.S. investors have endured at least 26 of them. And they've experienced "corrections" of 10% or more. There will be more in the future. Nobody knows when.

In the long run, the U.S. stock market has historically been an amazing wealth-building tool. But in the short run, it's always a gamble. Theoretically, it's great to stay invested. But realistically, in the short run, people need to take money out to live on. Especially those in or near retirement.

The fastest way to wreck a retirement portfolio is to be forced to sell shares in a bear market for income. That's what farmers call "eating your seedcorn."

More and more people are learning the lessons of past bear markets: Individuals and families cannot afford to lose the stock market gamble. Once you get within a few years of retirement, it's time to take your money out of the casino.

"Nobody should be taking on risks they can't afford to lose. That's not strategy. It's gambling."

Don't take risks you can't afford to lose

People in or near retirement shouldn't be taking on a lot of direct market risk. So you're right to be looking for ways to reduce exposure to the stock market. Nobody should be taking on risks they can't afford to lose. That's not strategy. It's gambling.

However, folks still want to be able to benefit from any further gains.

What if there were a way to "lock in" your current nest egg: No market losses, guaranteed — and still be able to participate in the strong economy?

The goal is to protect your entire portfolio — or as much of it as you like — against market losses.

A fixed index annuity can do something your broker can't — no matter what happens on Wall Street. It can provide you with a floor against persistent down markets and allow you to share in the gains when the market rises.

During a growing economy, a fixed index annuity can help people benefit as U.S. companies prosper while insuring their money against stock market losses.

Can I eliminate investment risk?

If you've done well with saving and investing over the years, it's time to protect it. That's what the insurance industry is for. Individuals can't absorb big stock market risks. But the insurance industry can. In fact, absorbing risk and protecting customers is the whole reason the industry exists.

That's why people use annuities: They're simply insurance contracts guaranteeing a minimum return, a minimum income, or both — regardless of what the market does.

How do fixed index annuities work?

The fixed index annuity is an increasingly popular tool. It's specifically designed to lock in gains, while still allowing the owner to benefit when the market does well. When stocks go up, you make more money. And those gains are locked in. Once they're in, they're in, no matter what the market does.

Regardless of a bear market of 20% or more or a small dip, your account value will remain whole with zero losses.

It's like a ratchet — your money only goes up when the market goes up and doesn't go down when the market goes down.

It's not the right tool for everybody. But it's something to consider if you meet these criteria:

  • You want to reduce or eliminate market risk.
  • You still want a share of market gains.
  • CDs, money markets and other so-called "safe money" alternatives don't return enough for you to meet your goals.
  • You want this money to support a guaranteed income for life.
  • You want access to your money in a long-term or nursing home emergency.
  • You think the market may face a downturn.
  • You won't need the money for several years (during the surrender period).

The advantages

Fixed index annuities have the following advantages:

  • Growth is tax deferred.
  • Safety of principal — guaranteed.
  • Options to convert to guaranteed lifetime income.
  • If annuitized, a portion of your income could be tax free due to exclusion ratios (exceptions: money held in traditional IRAs and other tax-deferred accounts).
  • Minimum guaranteed death benefit to heirs.
  • Assets go directly to named beneficiaries on death. No probate delays or costs.

Other considerations

There are always other considerations, of course. With fixed index annuities, there are some key factors to understand:

  1. There's a surrender period. You have to be able to allow your investment to accumulate with interest for a certain number of years. Otherwise, you may pay a surrender charge on withdrawals over your allowable amount each year. So this isn't the right tool if you think you may need a large lump sum during the surrender period. In situations like this, you can look at other alternatives that give you more flexibility.
  2. You give up some market "upside." So if the market goes up 10%, you don't get all 10%. You just get a part of it, depending on the index strategy you select. In exchange for providing market downside protection, the insurance company earns some of the upside.
  3. It's important to deal with highly rated insurance companies and trusted financial institutions. A fixed index annuity funded through a reputable institution gives you peace of mind knowing your assets will be there when needed most.

It is important to fully understand how the contract works — particularly how returns are calculated and credited, and how surrender charges and early withdrawal charges work.

These contracts aren't designed to generate huge equity-like returns; they're designed to protect you when markets drop. They'll generally do better than CDs and money markets over the long run. But possibly not in any particular year, and not as well as the market when it's going up.

Disadvantages of fixed index annuities

Like any financial instrument, fixed-index annuities have some disadvantages as well. Here are some disadvantages you should be aware of:

  • If you're under age 59½, there's a 10% penalty for early withdrawals that may apply (unless you convert the annuity to income, under Section 72(t) of the Internal Revenue Code). Generally, there are charges for early withdrawals that exceed your annual allowable amounts during the surrender charge period.
  • Income is not tax-free. Ordinary income taxes will generally apply to at least a portion of the withdrawal or income from the annuity.
  • Last in-first out (LIFO) accounting is made on lump-sum withdrawals. That is, the IRS taxes earnings first if you take out money.
  • Depending on the contract, it is possible to have a 0% year. Look at the minimum guaranteed crediting rate in the contract, and compare it to the maximum crediting rate cap. Choose the one that makes the most sense for you.

Important note

Fixed index annuities, like all annuity or insurance products, are not FDIC insured. The contract is backed by the claims-paying ability of the issuing insurance carrier. So it's important to pick a financially stable and highly rated insurance company.

Alliance America can help

An Alliance America financial advisor can assist you in maximizing your retirement resources and help achieve your retirement goals. Alliance America's planning process is focused on personalized retirement income planning. As fiduciaries, our advisors are required to act in your best interest, and we are dedicated to helping you achieve the retirement lifestyle you seek. You can request a no-obligation consultation by calling 888-864-2542 today.

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