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upside potential of annuities

The upside potential of annuities

How much your annuity can grow in value will largely depend on the type you purchase, how long you defer taking income, and how long you receive income.

If you purchase a traditional fixed annuity, its account value will increase annually based on the fixed rate of interest designated by the insurance company.

Variable annuities allow you to invest your premium funds in one or more subaccounts, which are mutual-fund like investments. Like mutual funds, these subaccounts offer different investment options in stocks, bonds, money market funds, and other securities. The money in those subaccounts will increase or decrease over time, depending on their performance.

The upside potential of indexed annuities

Indexed annuities earn interest based on the movement of a market index, giving them the ability to grow higher in value than fixed annuities that charge a flat rate of interest. However, you are not actually invested in the market or in any index. The insurance company simply uses the index as a measuring stick for how much to credit to your contract.

Indexed annuities also have a provision whereby the contract cannot lose value based on how the corresponding index performs. If the index loses 5 percent, 15 percent or even 75 percent in a given period, the annuity’s account value remains steady. Zero interest is the worst your contract can return in a given period. This makes it a safer alternative to a variable annuity.

Because indexed annuities do not lose principal, there has to be a limit on their upside. As an indexed annuity holder, you’re essentially trading unlimited interest rate growth for the protection against negative returns. Insurers have two methods of limiting an indexed annuity’s upside: caps and spreads.

A cap is a ceiling on interest rate growth. A typical cap might be 8 percent. That means your annuity’s account value can not increase more than 8 percent in any one period, regardless of how much the benchmark index increases. If the index increases 5 percent, your account value will increase 5 percent. If the index climbs 12 percent, the account value will be limited to 8 percent.

A spread, on the other hand, acts more like a floor. If your annuity has a 5 percent spread, your account value will increase by whatever percentage above 5 percent the corresponding index goes up. If the index increases 7 percent, your account value will grow 2 percent (7 – 5). If the index climbs 15 percent, your account value will earn 10 percent. But if the index only increases 3 percent, your account value will earn nothing for that period.

Downside protection equals upside potential

When considering the upside potential of fixed and indexed annuities, one should take into account that these types of products never lose value because of investment performance.

Let’s say you invest $100,000 in a regular investment that immediately loses 10 percent, taking the value down to $90,000. The investment will then have to gain 10 percent just to get you back to even.

Using that same scenario with an indexed annuity, the 10 percent loss does not impact your annuity’s account value: You still have $100,000. The next year when it increases 10 percent, instead of that 10 percent being added to a $90,000 balance, it’s being added to a $100,000 balance. Even if the annuity had a 7 percent cap, you would still have $107,000 in the annuity account value versus only $100,000 in the regular investment.

The protection against market losses is even more important once you begin withdrawing income from your retirement accounts. If a 401(k) or IRA is the primary source of retirement income, taking withdraws compounds the impact of negative investment performance. Think of it like this. If you withdraw 5 percent of your account value for income each year and your account loses 10 percent the first year of retirement, it has to increase in value at least 20 percent the second year just to get back to where you started (10 percent for the market loss and 5 percent for each of the first two years of withdrawals). This is not an issue when you’re receiving income from an annuity.

The longer you own it, the more it returns

The key to earning the best return on an annuity is deferring income as long as possible and receiving income as long as possible.

One annuity calculator shows that a 65-year-old man buying a five-year deferred annuity for $100,000 could receive lifetime income of $9,984 annually. If he lives to 90, his total income would add up to $199,680, which means he would nearly double his original investment. The average annual return would be about 4 percent. By the same token, if he defers for five years and receives income for five years, his annual income would be $24,070. That totals $120,350, which is about a 2 percent annual return.

In another example, a 50-year-old woman who defers income on a $100,000 annuity purchase until age 70 could collect annual lifetime income of $17,440. If she lives 10 years after beginning income, her total return would be just under 75 percent, or a 2.5 percent annual rate.

But if she lives 20 years, her total income would amount to $348,800, or nearly 3 1/2 times her original investment. The annual rate of return from her original investment would then be 8.75 percent.

Some insurance companies offer a bonus at the beginning of the annuity contract, typically 1 percent to 5 percent of the amount of premium you pay. So if you put $100,000 into an annuity with a 5 percent premium bonus, your contract will begin with a value of $105,000. Keep in mind that fees and expenses may be higher with a premium bonus product than with a regular annuity.

Because annuities are somewhat interest-rate sensitive, the current environment limits the upside potential of fixed and indexed annuities. Once interest rates rise, the upside potential of these products will increase as well.