An index-linked annuity might sound complex at first, but it’s worth considering if you want a mix of growth potential and protection. Finding an investment that offers a balance of risk and reward is a challenge with the ups and downs of the market. Registered index-linked annuities can potentially hit that sweet spot for you.
It’s a financial product that ties your returns to a specific market index performance. These are different from an indexed annuity because of how they are regulated. State insurance commissioners regulate index annuities, but the SEC and FINRA handles anything registered as a security.
An index-linked annuity gives you the potential for growth while still providing some downside protection. This blog will explain how these annuities work, the potential outcomes you might face, and what to consider before deciding.
How Does an Index-Linked Annuity Work?
A registered index-linked annuity (RILA), also known as a buffered annuity, is an annuity that lets you earn higher returns based on how the market performs while also offering some protection against losses.
Instead of offering a fixed return like traditional annuities, a RILA links your returns to a specific market index, such as the S&P 500. Unlike investing directly in stocks, a RILA shields you from some of the market’s full risks. It combines some attributes of fixed index annuities and variable annuities.
RILAs have built-in features to help protect you if the market behaves poorly. However, it can also prohibit you from taking full advantage of exponential growth. It’s a trade-off that comes with this type of annuity, but it can still yield favorable results.
These features include:
- The floor is the minimum level of protection provided by the annuity. If the market performs poorly, the floor limits the amount of your investment, which can lose value.
- A buffer absorbs a portion of losses up to a certain percentage. For example, a 10% buffer means you won’t feel the first 10% of any market loss because the insurance company absorbs the loss. This feature reduces market volatility’s effect on your investment.
- The cap rate sets the maximum return you can earn during a specific period, no matter how well the index performs. This cap limits earnings in strong markets but offers more predictability than direct market investment.
Potential Outcomes of a Registered Index-Linked Annuity
RILA outcomes vary based on market performance, annuity terms, and protective features like buffers, floors, and cap rates. The variables often make it difficult to determine your earnings with an index-linked annuity calculator.
You should always consult a financial advisor to help determine if this is the right decision for you. This will demonstrate some potential outcomes of a
RILA and if it suits your financial situation:
- What happens if market gains exceed the cap rate? If the market performs exceptionally well, your returns will be limited to the cap rate. If the market returns 15%, but your cap is 8%, your gain will be capped at 8%.
- What happens if market gains fall between the buffer and cap rate? In this scenario, market performance is positive but moderate. If the market returns 5% and your cap is 8%, you will receive the full 5% since it is below the cap.
- What happens if the market losses are within the buffer? When the market drops but stays within the buffer range, the buffer absorbs the losses. If the market falls by 7% and your buffer is 10%, you won’t experience any loss.
- What happens if the market losses exceed the buffer? If the market experiences a decline beyond the buffer, you will bear some losses. If the market falls by 20% and your buffer is 10%, you would be exposed to the remaining 10% loss.
Registered Index-Linked Annuity Pros and Cons
RILAs combine growth potential with protective features but have drawbacks. Weighing registered index linked annuity pros and cons can help determine if they fit your overall investment strategy.
These are some advantages of RILAs:
- Potential for growth: RILAs offer the chance to earn more than fixed annuities because they are linked to market index performance. This provides an opportunity to benefit from market upswings.
- Downside protection: Features like buffers or floors help limit your losses when the market declines. If the market drops 15% and your RILA has a 10% buffer, you only feel the impact of the remaining 5%.
- Tax deferral: RILAs are tax-deferred. Your investment can grow without immediate taxation until you withdraw funds.
- Customization: RILAs offer various buffer and cap rate options, letting you choose your preferred risk and potential reward level.
These are some disadvantages of RILAs:
- Limited upside: The cap rate on RILAs restricts how much you can earn during high-performing market periods. If the market grows by 10% but your cap is 7%, your returns are limited to that cap.
- Complexity and fees: RILAs have various terms and conditions that may require professional help to fully comprehend. Fees are often involved, including surrender charges if you withdraw money early.
- Market-linked risk: Although buffers give some protection, there is still room for potential loss. If the market drop exceeds your buffer, you will bear some losses.
- Less predictable: Unlike fixed annuities with guaranteed returns, registered index-linked annuities' performance depends on market conditions, making returns less predictable.
- Tax treatment: If you put non-qualified money into it, you’ll face income tax instead of the usual capital gains tax.
Are Index-Linked Annuities a Good Investment?
Index-linked annuities may be a good investment for your retirement planning if they suit your financial situation. They can provide long-term recurring income in your retirement with a high growth potential.
However, this also depends on your specific goals. Since the earnings are tied to a market, it’s less predictable. Also, all annuity contracts aren’t created the same. You should consult with a fiduciary financial advisor to get purely objective advice on whether this is a good option for you.
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Any comments regarding safe and secure investments and guaranteed income streams refer only to fixed insurance products. They do not refer in any way to securities or investment advisory products. Fixed insurance and annuity product guarantees are subject to the claims paying ability of the issuing company; not guaranteed by any bank or the FDIC.
Stewart Willis is the founder and president of Asset Preservation Wealth & Tax, a financial planning firm in Phoenix, Arizona. Investment advisory services offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.
The commentary on this blog reflects the personal opinions, viewpoints and analyses of the author, Stewart Willis, providing such comments, and should not be regarded as a description of advisory services provided by Foundations Investment Advisors, LLC (“Foundations”), an SEC registered investment adviser or performance returns of any Foundations client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment, legal or tax advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Personal investment advice can only be rendered after the engagement of Foundations for services, execution of required documentation, including receipt of required disclosures. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Foundations manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Any statistical data or information obtained from or prepared by third party sources that Foundations deems reliable but in no way does Foundations guarantee the accuracy or completeness. Investments in securities involve the risk of loss. Any past performance is no guarantee of future results. Advisory services are only offered to clients or prospective clients where Foundations and its advisors are properly licensed or exempted. For more information, please go to https://adviserinfo.sec.gov and search by our firm name or by our CRD # 175083.
