What is an Indexed Annuity?

Indexed annuities, also known as equity-indexed or fixed-indexed annuities, are a form of annuity contract that base their interest rate on the performance of a particular market index, such as the S&P 500.

As opposed to fixed annuities which offer a constant rate of return regardless of other conditions and variable annuities whose rates depend on investments made by the holder, this type is based exclusively on one specified source.

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How do Indexed Annuities Work?

For those wanting a regular income during retirement, an index annuity may provide the perfect solution. To access these advantages, you must first sign and fund a contract. This agreement will indicate how much you are paying for your annuity – either all at once in a lump sum or with scheduled payments – and outline when you can withdraw money.

When you invest with an annuity company, they offer multiple indexes to allocate your money in. Depending on which organization you are using, typical options include S&P 500, Nasdaq 100, Russell 2000, and Euro Stoxx 50. You can opt to spread your contributions across various indices or pick a single one for simplicity.

Rather than investing directly in index funds, many investors opt for the safety of an indexed annuity. As with any decision to forgo potential returns, there is a tradeoff; you are protected against losses but won’t earn as much as you would from other types of investments. An added benefit of this choice is that your investment’s growth and returns will be tax-deferred until withdrawn due to the tax-advantaged status given to such annuities, similar to that of 401(k)s or IRAs.

How does the Company Calculate the Return on Investment?

The return on investments in indexed annuities often confuses people. To comprehend how the insurance provider works out the rate of return, it is significant to be aware of exactly how the index is followed and what amount of the index earnings are credited to your account. Understanding these premises will help you determine how they calculate your investment return.

Your potential return from investing is closely linked to the fluctuations in a specified index. In order to measure this, many insurance companies use several different approaches for monitoring changes in that index’s value over time. Knowing this, it is essential to comprehend how this is calculated as it will affect your final credited amount.

What you can expect to be compensated by an insurance company(annuity company) largely depends on a range of components, all of which may influence each other and include:

The Cap: The Cap is a ceiling on the return over a specific period. For instance, if the index yielded 10% but the annuity has a cap of 5%, your account will be credited with a maximum return of 5%.
Participation rate: Generally, this rate dictates what percentage of gain from an index that will be credited to your annuity. For instance, assuming a market return of 8%, and a participation rate of 80%, you would receive 6.4% as a return (80% of 8%). In some cases though, there might be a cap in place that could limit your credited return to 3%, instead of 6.4%.
The Spread/ Margin/ Asset Fee: The spread/margin/asset fee is a percentage of the gain in the index linked to the annuity and may be subtracted from the gain. For example, if an index gained 8% and the spread fee was 2%, then the gain credited to the annuity would be 6%.
The Bonus: In addition to the first-year premiums collected, bonuses may also be added to the contract value. This bonus amount will likely become subject to an extended vesting schedule, that may exceed the surrender charge period time frame. As such, it is not unheard of for this bonus to be completely lost in the event that an individual decides to withdraw in their initial few years.
Optional Riders: Adding a rider to an annuity can provide valuable benefits, such as a minimum guaranteed income for life. However, by doing so the return credited to the account will be reduced.

Moreover, It is easy to overlook the fact that index returns used by insurance companies typically do not factor in dividends. As a consequence, returns from indexed annuities will also lack dividend income. This becomes significant when one takes into account how much of total equity gains are derived from dividends over time.

Can I lose money with an Indexed Annuity?

Unlike other investments, with a fixed index annuity, your money is secure; there’s no chance of loss as the least amount of interest that can be earned in any contract year is 0%.

Despite being linked to the stock market performance, your money is not directly invested. Depending on how the index performs, a portion of the gains will be credited to your account. Should it drop, however, neither profit nor losses will occur.

However, it’s important to note, that your account is subject to various management fees, and as such, these fees will be deducted from your account whether the account earns interest or not.

Pros and Cons of Indexed Annuities

All investment products have advantages and disadvantages that are typically the result of the type of product that will best meet your needs and circumstances and Index Annuities are no different.

Pros of Indexed Annuities

Low risk with protection from losses: Indexed annuities are an appealing option for investors seeking assurance that their savings are secure. Rather than being connected to the instability of the market, these annuities guarantee against losses and produce a portion of the profits when the index they’re linked to goes up. This type of investment allows individuals to take advantage of potentially high returns while protecting them from devastating losses.
Guaranteed Return on Investment: An indexed annuity may guarantee you a minimum return from its issuer, regardless of whether or not there is a loss in value from its associated index. As an example, you could still receive 2 percent even with an index showing negative returns.
Deferred Tax Liability: One of the considerable benefits of index annuities is that they provide deferred taxes on your earnings as long as you don’t take out money prior to turning 59½. This advantage enables tax-free growth and also an increase in interest rates. In addition, you can delay paying taxes until retirement age when they usually are lower than while you were working.
The Lifetime Income Rider: One of the greatest fears of retirees is outliving their income and savings. By adding a lifetime income rider to your indexed annuity contract, you can guarantee at least 5 percent and up to 10 percent per year for the next 10 to 15 years.

Cons of Indexed Annuities

The complexity of the Product: Choosing an indexed annuity as a retirement income option can be confusing due to the fact that they’re affected by market changes and have complex contracts. To make sure you are making the best decision for your future, it’s important to do your research before deciding on a plan. Or better yet, speak with an annuity specialist at LifeInsure.com.
Unpredictable ROI: Indexed annuities, connected to the stock market, are not a sure bet, as their return is dependent on the market index. In other words, one or more bad years in the market could mean lower returns than some other retirement options with greater stability and assurance.
No Earnings from Dividends: Investing in different stocks is an excellent way to achieve portfolio diversification and increase retirement savings. Not only can you earn equity, but dividends from these investments may be reinvested as well. On the other hand, indexed annuities are tied to a market index and are not intended to produce dividends like stocks do.
Early Withdrawal Penalties: An important factor to consider when investing in indexed annuities is the associated 10 percent federal tax penalty for withdrawals before age 59½. It’s also crucial to note that your contract may not credit all or some of the accrued interest should you decide to take out money prior to the end of the term.

The Bottom Line

Investing in indexed annuities is not a one-size-fits-all solution, so it is important to properly research what these products offer. Prior to making any decisions, you should analyze whether your needs can be best addressed through this type of annuity or another combination of investments.

Speaking with an experienced and reputable insurance and annuity professional can and should be part of your decision-making process. We encourage you to call us at 866-868-0099 during normal business hours or reach out to us through our website 24/7.

President at Intramark Insurance Services

In my 20+ years as an independent life and disability insurance broker, I have personally assisted thousands of clients with their life and disability insurance needs.

I believe that when people shop for insurance (or anything else, for that matter) on the Internet, they are looking for a simple, non-intrusive, non-pressure method of doing so.

I strive to treat my prospective clients with the utmost respect and I believe an educated prospect can make the right decision without sales pressure.

Being independent, I represent many highly-rated insurance companies and, because I am not beholden to any one insurance company, my focus is to find the right company and policy for each individual client.