Sometimes when learning about a new subject there is some confusion in the terminology. When I was studying to become a paramedic, I had to learn a whole new language. It was a language that medical professionals spoke, but when trying to explain a procedure or a possible diagnosis, I had to remember that my patients do not speak that language, so I would have to revert to layman’s terms.
It is no different in the financial world. When speaking with clients I have to keep in mind they do not speak, “Annuity”, or “Financialese.” It’s not uncommon that I’ll get a call from a prospective client asking me, “What are the rates on annuities?” Or “I would like an annuity; can you help me?”
This is where things can get lost in translation. There are numerous types of annuities, but some believe they are all the same. Even though most of them have a lot of similarities, they operate in very different ways.
Let’s start with some similarities of the two most common — Fixed Indexed Annuity and Fixed Interest Annuities:
- They are both issued by insurance companies
- They are both guaranteed to never lose your principle
- They both have withdrawal options to access your money, usually 10% after the first year
- They both can be annuitized to provide you with a guaranteed lifetime income
That’s pretty much where the similarities end. The biggest difference between these two products is how they grow your money. I’ll start with an analogy so you can visualize the big picture.
A Fixed Interest Annuity, or Multi-Year Guaranteed Annuity (MYGA), will offer you a guaranteed, or “fixed”, interest rate for the length of your agreement with the annuity company. Think of a bank CD. You give them a single sum of money for an agreed-upon amount of time, and in exchange, they will pay you a guaranteed interest rate that will compound for the length of the agreement. It’s that simple and straightforward.
To receive a guaranteed income from a Fixed Interest Annuity, you will most likely have to “annuitize” it. Meaning, you are surrendering the cash value of the account to the annuity company in exchange for a guaranteed monthly income.
The most common annuitization terms are:
- Life Only
- 5-Year Term Certain
- 10-Year Term Certain
- 20-Year Term Certain
- 30-Year Term Certain
“Term Certain” means that even if you pass away, that money will still be paid every month to your beneficiary for the entire length of the term. “Life Only” means just that – your life only. If you pass away in 6 months, the annuity company keeps the rest of the account value. The trade-off for that risk is normally a much higher payout rate.
However, most people do not annuitize Fixed Interest Annuities, nor would I recommend that. They are used to get an individual a higher-than-average guaranteed return for a guaranteed amount of time. Super simple and super effective!
For the most up-to-date interest rates on MYGA’s, check out my Atlas Annuity Rate Report where I update the highest guaranteed interest rates on the first Saturday of every month. You can locate that under the “NEWSLETTER” tab.
The best way I can explain a Fixed Indexed Annuity (FIA) is by using the analogy of a scoreboard. The annuity company will offer you several different stock indexes (scoreboards) that you can “track”. What that means is that your growth is dependent on how that stock index performs, but your money is not actually invested, or at risk, in the stock market. How and why all that happens is a subject for another newsletter, and I want to keep this as simple as possible.
If that stock index performs in a positive manner, i.e., there are points on the scoreboard, then you will be credited interest growth on your money. If there are no points on the scoreboard, or if that index goes down, you are credited 0%. Your money will never go backward inside of an annuity because of a market downturn. However, your returns could potentially be much higher than a Fixed Interest Annuity (MYGA).
There are 3 different ways you can be credited growth in a Fixed Indexed Annuity:
- Cap Rate
- Spread
- Participation Rate (or Par Rate for short)
Cap Rates, Spreads, and Participation Rate vary greatly depending on the company and the “scoreboard” you are tracking. But a good “rule-of-thumb” to remember is, the more volatile the index you are tracking, the lower the Cap Rate and the Par Rate will be, and the higher the Spread will be. And the more stable an index is, the higher the Cap Rate and the Par Rate will be, and the Spread will be lower.
Once you are credited with your interest growth, your gains are locked in forever and can never be lost due to a market downturn.
Another big difference between the Fixed Indexed Annuity and the Fixed Interest Annuity is the ability to add “riders”.
Riders are options that you can tag on to a Fixed Indexed Annuity, for an average expense of normally 1%, to add certain benefits such as a guaranteed income, without having to annuitize, and Long-Term Care enhancements that help offset the cost of skilled nursing confinement.
So, which one is right for you? Here is a snapshot of the highlights we went over in this newsletter and then you can decide…
Fixed Interest Annuities (MYGA):
- Issued by an Insurance Company
- Guaranteed Interest Rate every year for the length of the term
- Taxes on the growth are deferred until you access the funds
- You know exactly how much you will have at the end of the term
Fixed Indexed Annuities (FIA’s):
- Interest Growth is based on a Stock Market Index Performance (the scoreboard)
- Worst-case scenario for growth is 0%. You cannot lose money in an FIA due to a market downturn
- Your returns could potentially be much higher than a Fixed Interest Annuity
- Optional Riders
- Taxes are deferred on growth until you access the funds
That is a “30,000-foot view” of the major difference between these two types of annuities. There are all kinds of options available in both of these categories that go beyond the scope of this discussion, but for an in-depth look at how to best use annuities, take a look at my video series: “20% More Guaranteed Income In Retirement.” It’s broken down into bite-sized chunks and explained in plain English to make, what can be a difficult topic, very easy to understand. All you have to do is hit the “play button” below to start the first video. And then reach out to me with your questions at 636.926.6500 or click the “Schedule A Call” button in the top right corner of this page to have a short and down-to-earth conversation about protecting your retirement money.
All the best,
Marty