A fixed index annuity is an investment sold by insurance companies, whose return is based upon an index of stocks, such as the S&P 500. To purchase a fixed index annuity, a person makes a lump sum payment to the insurance company. The returns on the lump sum are based upon the performance of the index that is tied to the investment.
Fixed index annuities are sold as investments that produce a return to the investor based upon a fixed index, normally a stock index. One of the negatives of this type of investment is that the purchaser of the annuity does not receive the full return, only receiving the return after subtracting the value of dividends, according to FundAdvice, a website run by Merriman, which is an investment advisory firm. For example, if the index fund has an annual return of 9 percent, but 6 percent of that return is attributable to dividends paid by the companies in the index, then the owner of the fixed index annuity would only receive a 3 percent gain for the year.
According to the Financial Industry Regulatory Authority, or FINRA, fixed index annuities are sold as a long-term investment. If the money is not left long-term, a surrender charge is invoked, which can erase all of the gains made or even cause the investor to suffer a loss. Due to this negative aspect, an investment in a fixed index annuity should only be made if the money is not going to be needed over a considerable period of years.
Cap on Returns
FINRA points out that some fixed index annuities have a cap on returns. A cap is the maximum rate the annuity can earn in one year, no matter what the gain is on the index. This cap prevents the owner of the annuity from sharing in a great year for the index based upon the stock market returns. Thus the advantage of being tied to a market index is diminished when that index has big returns.
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