Riding Out the Retirement Red Zone with Fixed Index Annuities

Fixed index annuities help balance growth and capital preservation in your portfolio. You receive a fixed interest payment from the annuity but also limit your upside and downside potential. You could consider investing in a fixed index annuity when you're close to retirement.

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Key Takeaways

  • A fixed index annuity may help you participate in market growth while protecting your portfolio from volatility and market declines
  • A fixed index annuity may be a favorable instrument to hold when nearing retirement
  • Some annuities are more transparent than others; it’s a wide universe of products, so take enough time to choose wisely

Your retirement may be decades away or a matter of months. But at some point you’ll have to cross the retirement red zone—that final seven to 10 years before you stop working.

This period can be a bit tricky for some investors. You may still need to grow your portfolio, which entails taking market risks, and at the same time preserve capital, which entails reducing your market risk. It’s a dilemma—taking and avoiding risk at the same time. And while some investors may think “growth” and “capital preservation” are contradictions, combining them is possible if you know where to look. Consider a fixed index annuity.

How a Fixed Index Annuity Works

Enjoying the benefits of market gains while keeping your losses low might be difficult if not impossible with traditional assets such as stocks and bonds. But a fixed index annuity—essentially a type of insurance product—might help you pursue both, assuming you can accept limiting your upside in exchange for downside portfolio protection.

An annuity is a contract between an investor and an insurance company that’s designed to provide a steady income stream. You buy an annuity, either paying all at once or over time. After a predetermined waiting period (which can be long or short, depending on the annuity), you begin receiving regular income. There are many different types of annuities, so here’s some basic information on annuities to help get you up to speed.

A fixed index annuity is a different kind of beast—a hybrid of a couple types of annuities. Similar to a traditional “fixed deferred” annuity, it’s designed to provide regular interest payments. But instead of being fixed, the interest earned is tied to an index or indices—kind of like a variable annuity. Because it’s linked to an index, you may participate in some of the underlying indices’ positive returns, but—unlike most variable annuities—you’re also protected during negative years.

Hedging the Market’s Downside and Upside

Most fixed index annuities have both a “performance cap” on positive returns (a ceiling on your upside) and a “floor” to protect you from negative returns.

Say you bought an indexed annuity with an upside cap of 5%. Here’s what you could expect:

  • Limited upside: If the underlying indices generate 10% in one year, your upside gains would be limited to 5%. If the indices return only 4% in a given year, then you make the full 4% (because it’s under your performance cap).
  • Limited downside: If the indices generate a negative return, say, -15%, you might not receive interest payments that year. But you won’t take any losses during a down market, either.
  • “Insuring” what other investments can’t: If you invest directly in the market via stocks, ETFs, or mutual funds, there’s no guarantee that your investments would be protected from losses in the market. But a fixed index annuity is an “insurance” product, so it can protect your portfolio in a way other financial products can’t.

Give It to Me Straight and Simple

Annuities have earned the reputation of being highly complex and unnecessarily complicated instruments. But not all annuities have convoluted terms and conditions.

Indexed annuities can be straightforward and less complex.

“Locked-in rates” are indeed locked in upon purchase. The interest rate on a fixed index annuity may vary annually depending on the performance of the underlying indices. But once you purchase an annuity with a locked-in rate, say, at 5%, that’s what you should get.

Also, performance caps and floors should deliver at face value. If your performance cap is set to 4%, then you may receive an annual payment of 4% as long as the market returns 4% or more. If the market returns a negative figure, you take no loss. No other variables should get in the way of this basic agreement between customer and provider. Please note, however, that all guarantees are based on the claims-paying ability of the insurer.

Using Annuities to Ride Out the Retirement Red Zone

As you approach retirement, you may be looking to reduce your equities exposure to reduce your risk of loss. At the same time, you may also want to continue seeking growth to increase the value of your investments and future cash flow.

Rebalancing your stock and bond allocations might help you pursue this sweet spot in your portfolio. But remember that a fixed index annuity is designed to pursue this balance of security and relative growth. It may be worth considering as a potential addition to your portfolio.

Investors should carefully consider a variable annuity’s risks, charges, limitations, and expenses, as well as the risks, charges, expenses, and investment objectives of the underlying investment options. This and other important information is provided in the product and underlying fund prospectuses. To obtain copies of the prospectuses, contact an annuity specialist at 800-347-7496 or email annuities@tdameritrade.com. Please read them carefully before investing.

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Key Takeaways

  • A fixed index annuity may help you participate in market growth while protecting your portfolio from volatility and market declines
  • A fixed index annuity may be a favorable instrument to hold when nearing retirement
  • Some annuities are more transparent than others; it’s a wide universe of products, so take enough time to choose wisely
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Annuities are long-term investments designed for retirement purposes. Withdrawals of taxable amounts are subject to income tax and, if taken prior to age 59½, a 10% federal tax penalty may apply. Early withdrawals may be subject to withdrawal charges. Optional riders are available at an additional cost. All guarantees are based on the claims paying ability of the insurer. An annuity is a tax-deferred investment. Holding an annuity in an IRA or other qualified account offers no additional tax benefit. Therefore, an annuity should be used to fund an IRA or qualified plan for annuity features other than tax deferral. Product features and availability vary by state. Restrictions and limitations may apply.

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