For example, if you start with $100,000 and gain 50% in the first year, you will have $150,000 at the end of the year. If you lose 50% the next year, you will be left with only $75,000. Of course, the arithmetic average return that you received comes out to zero, but you’re down $25,000! You will need to earn at least 33.3% the following year just to break even again.
The possible fees and expenses of fixed indexed annuities are something to keep in mind, as they could drag down returns on an annual basis. In most cases, there will be a limit on the amount of interest that is paid based on a specific formula, such as a cap, spread, or percentage. An example of a cap would be when an insurance company pays 100% of the gain in the benchmark up to a specific, absolute limit, such as 10%.
The true beauty of indexed annuities lies in their reset feature. Let’s build on the previous example of gains and losses to see how this works.* Say you purchase a $100,000 indexed annuity contract on January 1with an annual crediting period. Let’s say the benchmark for that annuity rises 15% by December 31. The contract has a spread of 1.5%, so you earn 13.5% interest for the year, leaving you with a balance of $113,500 in the contract. The next year, the benchmark drops by 20%.
The above scenario can be compared to simply investing the same amount of money directly in the underlying benchmark over the same period of time. You will get the entire 15% gain in the first year, leaving you with $115,000. The 20% loss in the second year leaves you with $92,000. The 13% gain in year three then leaves you with $103,960— about $23,000 less than you would have in your annuity contract.
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