Shielding Your Retirement: How FIAs Limit Risk, Not Potential
In previous articles, we discussed about Annuities and saw illustration for couple of fixed indexed annuities(FIAs). This week let's compare annuities with other investment vehicles, in the risk aspect. Let's start from basics and get into the risk comparison.
- What is Annuity?
- What is Fixed Indexed Annuity?
- Comparison with Other Investment Vehicles
What is Annuity?
Annuity is a contract with the life insurance company that provides certain benefits in exchange for a deposit of money, known as premium
What is Fixed Indexed Annuity?
In this type of annuity, though our money is not invested in the stock market, the returns are credited based on how the stock market indexes does. We will have an option to choose from set of indexes and if those stock market indexes do good in a year, we will get some portion of that returns. If those stock market indexes do bad in a year, we will not get any returns, but we are protected from losses!!
Comparison with Other Investment Vehicles
Check the above picture. Different types of investment vehicles are arranged in the order of low risk to high risk. Look at the vertical arrow indicating increasing risk. Cash has the lowest risk and stocks has the highest risk. In the middle, see the green horizontal line that separates the investments where your money is protected vs risk of losing money due to market performance. Look at the titles "Principal/premium protected" and "Principal/premium not protected; can lose value". Any investment below the green line has principal protection. FIAs are below the green line but risk wise they are top among the investments below the green line. That's why they give the blend of security and decent returns.
Is there anything that did raise your eyebrows when you saw the picture? Bonds are riskier than FIAs? Let's review that point. Bonds are debt instruments where investors lend money to issuers (like governments, municipalities, or corporations) in exchange for periodic interest payments and the return of the principal at maturity. Bonds returns are inversely proportional to the interest rates. It might sound counter intuitive. But let's beak it down.
Bonds typically pay a fixed interest rate, called the coupon rate, which is determined when the bond is issued.
When Interest Rates Increase:
- New bonds are issued with higher interest rates to reflect the current market conditions.
- Existing bonds with lower coupon rates become less attractive because investors can now earn higher interest from the new bonds.
- To make existing bonds competitive, their prices in the market must drop.
When Interest Rates Decrease:
- New bonds are issued with lower interest rates.
- Existing bonds with higher coupon rates become more attractive, driving up their market price.
I guess that's enough on bonds. Don't get me wrong. Bonds are also good investment vehicle. I am just trying to explain why the FIAs are of lower risk in comparison. Does the above risk comparison picture spark any other questions? Post them in the comments section. I will answer every question asked.
That’s all for this week! Happy retirement planning!
