Disadvantages Of Fixed Indexed Annuities
The Top Fixed Indexed Annuity Disadvantages
As with any investment vehicle, fixed indexed annuities have their disadvantages. The fixed indexed annuity disadvantages are similar to those of other retirement savings instruments, including 401(k)s and IRAs. However, some disadvantages are exclusive to indexed annuities. The positives of the potential higher growth rate of a fixed indexed annuity, along with the minimum guarantee, will often outweigh the disadvantages. However it is important to understand the pitfalls nonetheless.
- Limited Market Upside – Fixed Indexed Annuity returns are tied to a market indexed – though often limited by a threshold or cap.
- Moving Parts – For many FIAs, the terms and conditions may change after you purchase it.
- Lengthy Contracts – FIAs tend to be longer term contracts.
Limited Upside Potential
The primary benefit of any fixed annuity is safety. They provide the peace of mind that comes from knowing the annuity will never decrease in value. The same is true for fixed indexed annuities. In order for the insurance company to provide safety of principal, they must limit the upside potential of fixed indexed annuities.
There are a variety of mechanisms an insurance company may use to limit the upside of a fixed indexed annuity, such as a cap, spread, or a participation rate. Regardless of which method is used, the end result is the same. It prevents the annuity from capturing the full returns from the index of which it’s tied.
These limitations are necessary because of the ways in which the insurance company reinvests annuity premium. They purchase a combination of bonds and options to hedge against market losses. This allows them to ensure the downside protections within an annuity.
Another disadvantage to fixed indexed annuities is the fact that many of the products available today have features which can change throughout the contract. These changes can have either positive or a negative impact on the policy, so it is important to know which features can change on the annuity you purchase.
The most common moving part for a fixed indexed annuity is the crediting method. The cap rate or participation rate is often times only guaranteed for the first year of the contract. They can move up or down, depending on market conditions, which will directly effect the performance of the annuity. When purchasing a fixed indexed annuity, make sure to research how much the crediting method can change over the course of the contract.
Many fixed indexed annuities also offer a traditional fixed rate option in addition to the indexing options. The owner of the policy may choose to allocate a portion of the funds into the fixed bucket. The fixed bucket grows at a predetermined rate. As with the crediting methods, fixed rates within a fixed indexed annuity can often change from year to year. Fortunately most contracts also allow the policy owner to reallocate annually, so if the renewal rate isn’t desirable, you may place those funds in the indexing option bucket.
Lengthy Contracts With High Surrender Charges
Fixed indexed annuities tend to have longer contract terms with higher surrender charges. There are some exceptions, but the majority of FIAs will have a contract length of five years or longer. A general rule of thumb for all fixed annuities is the longer the contract, the higher the initial surrender charge.
A surrender charge is a fee or penalty imposed on the account value should the policy owner request an early termination of the contract. It is important to keep in mind that the surrender charge never comes into play if you leave the funds in the annuity for the entire length of the contract.