Wouldn't it be great if you could invest in the stock market with its potential for growth and at the same time have protection against the possibility of loss?
While stocks and bonds can expose you to both gains and risk, some annuities promise to get you closer to realizing the benefits of growth with limited losses—although with important caveats. Two common annuities that fall into this category are fixed indexed annuities (FIAs) and registered index-linked annuities (RILAs), also known as buffer annuities. They are types of tax-deferred annuities that can offer you participation in the market while limiting your downside risk.
These annuities can be complex, and the features which may protect you from the market's downside can come with explicit or implicit costs and fees, depending on the product, including in many cases surrender charges if you take your money out early. For instance, index-based annuities don’t grant you full access to an index's returns, and that can place a limit on your potential future gains.
What are annuities?
As a refresher, an annuity is a contract between you and an insurance company that is generally designed to guarantee income in retirement either for life or a predetermined number of years. They generally fall into 2 broad categories: income and tax-deferred annuities. With income annuities, in exchange for an upfront lump sum, the insurance company begins making income payments either immediately or sometime in the future depending on the date you set. With tax-deferred annuities you invest a portion of your savings until you are ready to start receiving regular income payments. Tax-deferred annuities let you defer taxes on any gains until you start taking withdrawals.2
Tax-deferred annuities can be an additional savings tool for people who have maxed out retirement accounts with regular contributions. Some, including fixed indexed annuities (FIAs) and registered index-linked annuities (RILAs) can even protect your investment from losses.
Find out more about annuities in Viewpoints: Understanding annuities.
How FIAs and RILAs differ from other annuities
Fixed indexed and registered index-linked annuities are types of deferred annuities that can help with long-term saving goals. The returns of fixed indexed and registered index-linked annuities, as their names imply, are tied to stock market indexes. That may sound complicated, but if you've heard of index funds whose returns are also tied to an index, you can start by picturing it like that. Only with these annuities you don't own any of the underlying securities and the issuer typically limits gains to make guarantees against losses. (More on that later.)
What is a fixed indexed annuity?
A fixed indexed annuity is a deferred annuity designed to provide growth potential based on the returns of a market index (e.g., the S&P 500® Index) while providing protection against negative returns of the same market index. In addition, they frequently offer a guaranteed level of lifetime income through optional riders.
What is a registered index-linked annuity?
Registered index-linked annuities also link their growth to the movement of a market index, allowing investors to participate in some market gains. Like fixed indexed annuities, these products typically offer some protection against losses and typically cap the return you can earn over a specific period of time. They also may offer a guaranteed level of lifetime income through optional riders. However, a key difference is that RILAs typically offer greater market participation than fixed indexed annuities in exchange for less protection against losses.
Registered vs. unregistered index-based annuities
While both fixed indexed annuities and RILAs are regulated by state insurance authorities, RILAs are also registered with the federal Securities and Exchange Commission (SEC). FIAs are not.
That distinction is important because the person who sells you a RILA must be registered and have passed the Series 6 or Series 7 examinations. Individuals who pass these exams are qualified to sell mutual funds and, if state-insurance licensed, registered annuities such as RILAs and variable annuities, which can be more complex, but may also expose you to greater market risk.
For example, a registered indexed annuity might offer a feature called a buffer, which can protect your holdings against a percentage of losses, so you could actually lose principal. By contrast, FIAs are designed to limit losses to your principal, and might offer you a floor, which is an absolute limit against losses. Note: You can lose principal in a fixed indexed annuity due to surrender charges if you withdraw assets before the surrender period is up.
So if you are considering purchasing one of these types of annuities, you might want to think about whether it's a registered or unregistered product. If the annuity you purchase is unregistered, your sales advisor may discuss complex indexes, but they may not be licensed to sell you securities, such as mutual funds.
What it means to purchase an annuity tied to index performance
When you purchase an FIA or RILA your performance is tied to an index that you choose when you buy the contract. Various indexes offered typically include the S&P 500 for large-cap companies, the Russell 2000 for small caps, the tech-heavy Nasdaq, and the MSCI EAFE, which represents the international developed markets index. Some even offer customized indexes from major financial institutions.
But unlike an index fund, you don't actually own any of the index's underlying securities. Your performance is tied to an index, which means you are unlikely to fully participate in an index's performance. For example, returns from FIAs and RILAs generally exclude dividends, which tend to add significantly to equity returns over time. For example, over the past 20 years, ending December 2023, the S&P 500 Index has gained 7.55% annually without dividends and 9.69% with dividends.
Hypothetical impact of dividends on equity returns
Instead, these annuities typically calculate your return from the index based on a participation rate and/or a cap, which essentially grants you a percentage of the return and limits the return, respectively, rather than providing the full return. Additional limits on your return may also apply, based on the conditions of the annuity contract.
Here are some common features and terminology you might encounter with FIAs and RILAs.
- Cap. Many put a cap on the returns. For example, if the index returned 10% but the annuity had a cap of 5%, your account receives a maximum return of 5%.
- Participation rate. This is the percentage of the index's return the insurance company credits to the annuity over a set period. For example, if the index goes up 8% and the annuity's participation rate is 80%, a 6.4% return (80% of the gain) would be credited. Many annuities that have a participation rate also have a cap, which in the example above would limit the credited return to 5% instead of 6.4%.
- Bonus. A percentage of the first-year premiums received that is added to the contract value. Typically, the bonus amount plus any earnings on the bonus are subject to a vesting schedule that may be longer than the surrender charge period schedule. Given the typical vesting schedule, the bonus may be entirely forfeited upon surrender in the first few contract years.
- Buffers and floors. A buffer protects against market losses up to a specified percentage. A floor is an absolute limit on losses, also specified as a percentage. Note: While other options exist to protect against or limit losses, these are the most common.
- Length of the guarantee. Elements (e.g., caps, participation rates) may renew on a schedule. Some products reset participation rates and caps annually, and other products hold steady with the same rates for several years at a time.
- Riders. These are extra features, such as minimum lifetime guaranteed income, that can be added to the annuity for additional costs, further reducing the return credited to the account.
It's important to keep in mind that the performance of the annuity depends largely on the combination of features mentioned above and the index that you choose. As a result, the performance of FIAs and RILAs can be challenging to calculate and even more difficult to compare to one another.
How a buffer annuity works
Say your annuity has a 10% buffer and the index loses 10%. In that case, the insurer absorbs the loss, and your return will be flat. If the index falls 25%, the insurer absorbs the first 10% and you would see a loss of 15%.
_Edited File.png "Chart illustrating how a buffer works with a registered index-linked annuity (RILA). A hypothetical RILA with a 10 percent buffer would absorb losses in the linked index up to that amount, but it would also put a cap on potential gains.")
For illustrative purposes only.
Bear market losses, by definition, exceed the protection offered by the typical buffer annuity, providing protection for the first 10% of loss. (Bear markets are usually defined by a fall in prices of 20% or more from a recent high). The S&P 500 lost about 50% of its value in the Great Recession of 2007–2009. While a 10% buffer might take some of the sting out of the market losses, it won’t protect you entirely.
Alternatives to indexed annuities
FIAs and RILAs are not the only options for investors seeking growth while limiting losses. A diversified portfolio of stocks, bonds, and funds can also help you achieve similar goals but with potentially fewer limitations on growth.
- Professionally managed portfolios, such as one offered through a defensive portfolio advisory service can also help reduce the impact of sharp movements in the markets.3
- A defensive portfolio may seek to include more conservative stock investments, high-quality bonds, and alternative investments that are less correlated to the performance of traditional asset classes.
By investing defensively, you may be able to implement an approach that could result in shallower dips in your portfolio when the broader market is in decline. Note: Investors may want to work with a professional who can devote more time and attention to constructing and maintaining a defensive portfolio to help ensure their plan remains on track.
There are other annuity solutions that can provide growth with protection.
- A variable annuity with a guaranteed minimum accumulation benefit (GMAB) rider can give you a floor against losses.
For a fee, the GMAB rider guarantees that at the end of a defined holding period—typically 10 years—you'll have at least the same asset value you started with, assuming you haven't taken any withdrawals. Another potential benefit is that most GMAB riders let you reset the level of principal protection each year if your investments have grown in value, which in turn would restart the defined period.
- If having a guaranteed stream of income is important, you might consider variable annuities with a guaranteed lifetime withdrawal benefit (GLWB) rider.
This approach combines growth potential with the ability to "lock in" some of your future retirement income today, protecting it from potentially declining markets down the road. Additionally, it can help shelter your retirement savings from market volatility, inflation, and the risk you may outlive your savings. The variable annuity's costs and limited equity participation are the only obstacles to capturing potentially positive returns, making such an alternative easier to evaluate.
- A further option to consider is what is known as an anchor strategy, which uses a fixed, predictable asset such as a certificate of deposit (CD) or single-premium deferred annuity (SPDA) to protect a portion of your principal in conjunction with an equity component to pursue growth for the remainder.
How to decide if a fixed-indexed annuity or registered index-linked annuity is right for you
To evaluate indexed annuities, investors should consider how they might have performed in a variety of past markets. "Balancing risk and reward requires a thorough understanding of your available investment choices and their potential outcomes in a variety of market conditions,” says Tom Ewanich, vice president and actuary for Fidelity. "To make sure they're investing appropriately, buyers have to understand what these products are, how they work, and evaluate their tradeoffs."
For more information on strategies for protecting savings, read Viewpoints: Protecting yourself from fear of loss.