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Understanding Indexed Annuities

The most recent addition to the annuity product line is indexed annuities. These, so called “hybrid” annuities were introduced as an alternative for investors who are not satisfied with the returns from fixed annuities, but can’t tolerate the risks associated with variable annuity investment accounts. They do offer investors the opportunity to participate in the returns of stock market on a limited basis, while preserving their principle. And, like all annuities the earnings are not currently taxed.

While, on the surface, indexed annuities may seem like the perfect investment for risk adverse investors who, they have earned a dubious reputation for being somewhat difficult to understand due to their complex structure. But any investment that allows for participation in the positive returns in the stock market while protecting the principle against the negative returns is bound to be more complex than your basic mutual fund or annuity. Understanding indexed annuities requires knowing how all of the moving parts work in the contract.

How Indexed Annuities Work

Market Participation

With an indexed annuity the yield on your account value is tied to a stock index, such as the S & P 500. The amount actually credited to your account is based on the percentage gain in the index from year to the next. For example, if the S & P 500 gained 20%, the rate credited to your account will be based on that gain.

Participation Rate

The way indexed annuities are structured, your account won’t be credited with the full 20% gain in the market. Each indexed annuity sets a participation rate which is a percent of the actual gain that is applied as a credit to the account. So, if the indexed annuity in our example has a 70% participation rate, the actual rate credited to your account would be 14%.

Participation rates can range from as low 25% to as high as 90%. In many indexed annuities, the participation rate may only be guaranteed for a short period, so, while a 90% participation rate may seem attractive, it could drop to a less attractive rate. It may be better to have a lower participation rate as long as it is guaranteed not to drop.

Rate Cap

Indexed annuity contracts also include a rate cap which is a maximum rate that will be credited no matter how big the gain in the index. Rate caps can range from 6% to as high as 15%. Using our example, if your indexed annuity had a rate cap of 10%, your account would be credited with 10%, not 14% which was your participation credit. Rat caps are a way for the insurer to build up their reserve in order to provide protection against downside moves with a minimum rate guarantee.

Minimum Rate Guarantee

With indexed annuities, there is no downside, literally, because, when the market index has a negative return, your account will still be credited with a minimum guaranteed rate. Obviously, indexed annuities offering high minimum rate guarantees would be more attractive over the long term.

Annual Reset

As a further protection against downside moves in the market, as well a way to preserve the gains in your account, each year your account values are reset so that your prior year’s gains are locked in and your increased account value becomes the new basis in your contract. In other words, your principle can never decline.

Standard Annuity Features

The rest of the key features of an indexed annuity are the same as any other deferred annuity: Earnings are tax deferred; Surrender periods allow for 10% withdrawals without penalty and last for a certain number of years; and, the account balance can be converted to guaranteed period payments for life.

As it relates to guaranteed periodic payments, the advantage of indexed annuities, is that the payout rate can also be tied to a stock index, so that income can rise above a minimum guaranteed payout.

And, yes, there are the standard annuity fees and expenses, such as mortality expenses and many indexed annuities are sold with front end sales loads. The market for indexed annuities today is very competitive and products can be found with low expense ratios and low or no sales loads. The more important factors to consider when comparing indexed annuities are the participation rates, the rate caps and the minimum rate guarantee.


Indexed annuities do offer the best of worlds to investors who would like to increase their returns over fixed yield investments, but are concerned with the preservation of their principle. While the limits to indexed annuity returns (i.e. participation rates and rate caps) may seem discouraging, when weighing risk and reward, no other investment can offer market-based returns with, essentially zero risk.

If you have a long term investment horizon, low risk tolerance and you find yourself in the higher tax brackets, indexed annuities are an ideal way to put a portion of your retirement funds to work. And, as with all annuities, if you’re concerned with the possibility of outliving your income, indexed annuities can also provide the peace-of-mind with the added security of guaranteed lifetime income.

How Can Annuities Help You

Anyone who has been investing for a while has probably heard of annuities. Either they know of someone who owns one, or they have been pitched one by their banker or their insurance agent, or they’ve been the target of an advertisement that found its way into their email inbox. For some people, annuities are some esoteric term used to in connection with old people. Yet, hundreds of millions of dollars continue to find their way into annuity contracts each year. So, somebody is figuring out how annuities can actually help them achieve their financial goals. For everyone else, let this be your primer on how annuities can help you.

Do You Fit the Annuity Profile?

Or, rather, do annuities fit your financial profile? For a lot of people, annuities conjure up the image of a stodgy investment with stingy returns suitable for older people who would otherwise keep their money in their bed mattress. While that may have been an appropriate characterization four or five decades ago, today’s annuities, and their owners, have broadened out to the extent that nearly half of the country’s population are very likely to have the right profile for one type of annuity or another.

Generally, people who can benefit from tax deferred earnings on their investments, and who are concerned more with the return of their principal as opposed to the return on their principal are candidates for annuities. The surprise for most people is that they can also help them achieve their accumulation goals with competitive returns.

Regardless of whether you view yourself as a conservative investor or one with risk tendencies, if you are one of the 50 million Americans who lay awake at night wondering if you your income will last as long as you do, then annuities may prove to be of more help than any other investment you could choose.

Help Achieving Financial Goals

Competitive Returns:

The returns earned on annuities can be compared with just about any other investment vehicle. Whether you are considering fixed yield vehicles such as bank CDs or variable return investments such as mutual funds, there is an annuity that can generate equivalent returns. Fixed yield annuities are extremely competitive with the rates on CDs, and, in fact, tend to be higher in most instances. Variable annuity contracts are comprised of professionally managed investment accounts similar to mutual funds.

Deferred Taxation:

When you can combine competitive returns with taxed deferred accumulation of you earnings, you have faster accumulation. Annuities enjoy the same tax deferred treatment as your qualified plan, so for the assets that you accumulate outside of your qualified plan, annuities can provide the same tax advantage.

Portfolio Stability:

For people with diversified investment portfolios, annuities can add the much needed stability to otherwise volatile returns. Fixed annuities provide a safe, steady, guaranteed return which can moderate any decline in portfolio value. Indexed annuities with potentially higher returns linked to stock index performance also provide a hedge against declining values with their minimum rate guarantee. Even some variable annuity contracts offer an option which provides for a minimum rate guarantee in the face of a declining market.


After the big crash of 2008, and the wild market gyrations that followed, peoples’ nerves are frayed, and many who fled the market are very timid about getting back in. While many people want to be able to keep their money working harder for them, what they want more than anything is “peace-of-mind”. Annuities add extra layers of security to an investment portfolio that might allow some people to take some more risk with a portion of their money. Because the principal and earnings are guaranteed (except with variable contracts), annuities are the safety net that most investors need.

Secure Retirement Income:

It’s what everyone wants, and yet fewer and fewer people are reaching the retirement phase of their life secure in the knowledge that they will have enough income to meet their lifestyle needs for as long as they live. Annuities are unique in their ability to convert accumulated retirement savings into a guaranteed stream of income that will last a lifetime. The income payments from an annuity bring certainty and predictability to an income portfolio that could be subject to market fluctuation.

Asset Protection:

It’s not until most people get sued, or become the subject of some potentially expensive litigation or debt collection, before they begin to think about protecting their assets. Annuities are one of a few financial instruments that can find protection in most states from claims and liabilities. Each state has established its own rules for exempted assets. Some states provide for complete exemption while some may not, so it would be important to check with your state to learn to what extent annuities are exempted.

Access to Funds

: Annuity critics are quick to point out that annuities are illiquid investments because of the high surrender fees charged for withdrawals. Withdrawals taken during the surrender period that exceed 10% of the account value are charged a fee, however, the fee is reduced by a point each year until it reaches zero, after which there is no charge for a withdrawal. For most people who invest in annuities with a long term time horizon, the ability to access 10% of their funds is usually sufficient for meeting any short term need they might have.


Certainly annuities don’t fit the financial profiles of all investors, but there aren’t many that the unique features of an annuity couldn’t help in achieving their financial objectives. Annuities, as an investment alternative, should not be dismissed out of hand until they have been fully evaluated in light of your own particular needs and financial profile. When used in the context of a complete retirement planning portfolio, annuities can help you in a number of ways.

Variable Annuities Explained

Variable annuities are, once again, climbing back into the spotlight as a popular alternative to mutual funds and other taxable investments. While their resurgence is due, in part, to the recent surge in the stock market, much of the renewed attention is a result of several key changes made in the product which have increased their appeal for long term investors. For people who haven’t considered variable annuities in recent years, a fresh look at variable annuities may be worth their while.

Variable Annuity Overview

Variable annuities were introduced in the 1950s as an alternative to fixed annuities which provided savers with a way to accumulate funds for retirement in a tax deferred account. Instead of an accumulation account which earned a fixed rate tied directly to the life insurer’s general investment account, variable annuities were given separate accounts that were tied to stock and bond investment portfolios giving investors the opportunity to earn unlimited returns on a tax deferred basis. In the high tax bracket years of the 1950s, 1960s, and 1970s, this proved to be a major attraction for variable annuities and their sales skyrocketed.

The Separate Investment Accounts

The separate investment accounts of variable annuities are very similar to mutual fund accounts. They are professionally managed portfolios that invest in various segments of the stock and bond markets. A variable annuity usually offers a selection of five to 12 accounts that enable investors to devise an allocation strategy around their specific objectives and risk tolerance. Most variable annuities allow for several transfers among the various accounts each year so the allocation can be rebalanced or changed as needed.
As with mutual funds, past performance is no indication of future performance; however, established variable annuities with long track records for their separate account can provide some measure of management’s capabilities in up markets and down markets. The more important indicator of a separate accounts future prospects is the soundness and continuity of the professional management team. Separate accounts are selected largely based on their stated investment objective and philosophy which is established by the management team. If the separate account has a revolving door of management teams, it may be an indication of internal problems, and changing management teams are likely to change the investment objective over time.

Information on the separate accounts, the management teams, their investment objective, performance history and management expenses can all be found in the prospectus which can be obtained before any investment decision is made.

Fund Access

Many people steer clear of variable annuities because they are considered to be illiquid investments. While they are more likely to perform better if left untouched for the long term, variable annuities are liquid to the extent that the funds inside the separate accounts can be accessed each year. Investors are able to withdraw up to 10% of their account values each year without any fees. For someone with $100,000 invested, that means $10,000 can be accessed for any use.

Amounts withdrawn over 10% will be charged a fee if the withdrawal is made within the surrender period which can last for five to 10 years (some variable annuity products don’t have a surrender period, however, they may charge a high front-end sales load). The fee can be high at first, but then it gradually declines each year of the surrender period until it drops to zero. At the end of the surrender period, funds can be withdrawn without charge, however, if the withdrawal occurs prior to the age of 59 1/2, the IRS may levy a penalty of 10%.

Death Benefit

One of the distinguishing features of variable annuities is the guaranteed death benefit that is common with all annuities. The death benefit assures investors that, no matter how their separate accounts perform, their heirs will receive no less than the original investment. If you can imagine those unfortunate investors who died after losing half the value of their 401k accounts in the last market crash, you will realize how valuable this benefit can be. Many contracts have a step up provision that ratchets up the basis to include the prior year’s gain, so the guaranteed death benefit will increase along with the value of the separate accounts.

Minimum Rate Guarantee

Many variable annuities now include an option (at an additional cost) that ensures that, even in a market decline, a minimum rate of return will be credited. For an investment that offers the opportunity for market returns, this would seem to be counterintuitive as higher rewards usually come in the face of higher risk. Many investors, who suffered through painful years in the market over the last decade, may find that this “insurance premium” is worth the cost.

Minimum Income Guarantee

Like all annuities, variable annuities can be converted into an income annuity. Unlike a fixed annuity in which the payout rates are fixed, the payout rates of a variable annuity are linked to the underlying investment portfolios. So, when the markets perform well, the payout can increase, and, when the market declines, so too can the payout. For investors who believe that the overall trajectory of the stock market is up, they would expect that their payout will rise over time. Investors can purchase an added layer of protection through a minimum income guarantee which will create a floor below which the payout cannot fall.

At What Cost?

One of the complaints that spew from variable annuity critics concerns their high expenses. While it’s hard to argue that their expenses run a little high, it is important to place these costs in the overall context of what the investment provides. All annuities provide a guaranteed death benefit, and for variable annuity owners, this can be a very important benefit. Mortality costs of approximately 1% of the account value are deducted each year to cover the insurance risk.

As with mutual funds, variable annuities have investment management expenses. These fees can vary from as low as .5% to as high as 1.5%. The difference lies in how actively the accounts are managed. Aggressive stock accounts that invest in high growth stocks will usually have a higher turnover than a government bond account, hence the difference in fees. These fees aren’t any higher than those found in mutual funds, however, they are added on top of the mortality expenses.

Once extra options, such as the minimum income rate or income guarantees, the fees climb higher. It’s not inconceivable that the total annual expense fee could run as high as 4% depending on how many options and extra guarantees are added. Many critics focus on the impact such a high expense rate will have on investment returns, which is a reasonable concern. What they tend not to focus on is the amount of capital that is preserved during extended down markets. If, after all expenses, your separate account values netted 0% return in a down market, would that be worth the expense?


Variable annuities are complex investments, and the marketplace is vast consisting of a seemingly unlimited variety of products offering many different bells and whistles. For a long term investor, concerned about taxes and capital preservation, they can a great addition to an overall investment portfolio. But, it would be important to study the prospectus carefully, compare all fees and sales charges, and try to limit your search to well established variable annuity providers.

Understanding SPIA Annuities

It wasn’t too long ago when people would plan their whole lives around a leisurely and secure retirement. Buoyed by huge equity balances in their homes, and their bulging 401(k) plans, most people in the 1990s and early 2000s sailed into retirement without a care in the world. These days, pre-retirees are planning on working longer, living on less, and hoping that they’ll have enough income to last their lifetimes. What a difference a decade makes. It’s no wonder that SPIA annuities are, once again, garnering the attention of the retiring population.

SPIA annuities (Single premium immediate annuities) may not be the cure-all for people whose retirement plan accounts come up short, but for retirees who find themselves losing sleep over the possibility that they may outlive their income, they provide the ultimate cure. With over 70% of Baby Boomers laying awake at night worried over their retirement income, understanding SPIA annuities may be their first step towards getting the sleep insurance they need.

SPIA Annuity Basics

The concept of a SPIA is actually fairly simple: An individual deposits a lump sum of money (single premium) with a life insurance company in exchange for a promise to provide a continuous stream of income for a specific period of time or the lifetime of the individual. They enter into a contract, and the future payments become an obligation of the life insurance company. The depositors give up access to their deposit except through the period payments, and the insurer guarantees that they won’t outlive their income.

Drilling Down on SPIAs

When investors make the decision to invest in an SPIA, they approach the life insurer with one of two known variables: The amount of income they want to receive, or the amount of money they have to deposit. For the first variable, the life insurer will calculate how much capital needs to be invested in order to generate the amount of income needed. For the second variable, the insurer will calculate how much income can be generated from the invested capital. In both cases, the insurer applies the same factors: the investor’s age, the number of payment periods involved, and an assumed rate of interest that will be paid on the annuity balance. For lifetime SPIAs, the insurer determines the number of payment periods based on the investor’s life expectancy.

The payout amount is determined by dividing the total number of payments into the amount capital available which includes the original deposit plus the project interest accumulation over the entire payment period. An exclusion ratio is calculated to determine the amount of the payment that will be excluded from taxes because it is a return of principal.

The Insurance Aspect of SPIA Annuities

SPIAs are, essentially, longevity insurance policies. Whereas life insurance insures the risk of dying to soon, SPIAs insure the risk of living too long. Even though the payout amount is calculated using a person’s life expectancy to determine the number of payment periods, payments are guaranteed to continue even if life expectancy is exceeded.

Leaving SPIAs Behind

SPIAs that are structured as a “single life” annuity, guarantee payments for as long as the annuitant is alive. When the annuitant of a single life annuity dies, the life insurer retains the remaining annuity balance.

In situations where a spouse is involved, a “joint life” annuity would ensure that the surviving spouse would continue to receive annuity payments for the remainder of his or her life. In this case, the life insurer is insuring two lives, so the payout amount is adjusted down to offset the cost of insurance.

If the annuitants want to have their heirs receive the annuity balance after both deaths, a refund option can be added that will pay the balance of the annuity to named beneficiaries in installments.

Planning for Maximum SPIA Income

Because the SPIA payout rate is calculated using the number of payment periods, the fewer payment periods there are, the higher the payout amount will be. With a shorter overall payment period, the exclusion ratio will be higher which means the amount of the payment excluded from taxes will be higher. Ideally, SPIAs should be used as late in retirement as possible, but, of course, this strategy can only work if there are other sources of retirement income that can cover living needs in the early stage of retirement. This strategy would make sense for someone who plans on generating income from a job or a business while in retirement enabling them to delay the income from an SPIA annuity.

Buying the Right SPIA Annuity

SPIAs are available through most major life insurance carriers of which there are hundreds. It can make the task of selecting just the right one very daunting. Online annuity sites make it fairly easy to compare payout rates along with the various payout structures, however, it could still involve looking at dozens of SPIAs. When trying to narrow the field in a competition, it is important to have a set of criteria that will enable you to select out products quickly and easily.

Perhaps the most important criterion for selecting an SPIA is the financial strength of the life insurer that is obligated to make your annuity payments. Your annuity payments are secured by the assets of the issuing life insurer, so it would make sense to choose among those who are deemed to be in the strongest financial condition.

Life insurers that earn the highest ratings from the independent rating firms are considered to be the strongest financially and able to meet their obligations in the toughest of economic environments. If, in your comparisons, you find that the difference in payout between an “A+” rated company and a “B+” rated company is only $35 a month, is that a sufficient amount of money over which to lose sleep? Probably not. The guarantees and security of SPIAs are only as good as the company that backs them.

Retirement Planning and Annuities

The reports are stunning. Nearly 75% of America’s Baby Boomers are approaching retirement with major concerns over their ability to fund their retirement. Studies indicate that 45% of American’s will not have accumulated enough savings to provide adequate income in retirement. Whatever happened to retirement planning? The sad reality is that most people don’t plan to fail; they simply fail to plan adequately.

It’s likely that many of today’s retirees had some sort of plan for retirement. But it is also possible that many pre-retirees were lulled into complacency as they watched their 401(k) plans and home equity balances balloon during the 1990s and early 2000s. For many pre-retirees that was their retirement plan. Then, when the bubble burst in 2008, they found themselves back where they started fifteen years ago. Certainly no one expected that their retirement savings and home equity would be halved overnight, but then planning is about anticipating the unexpected.

Retirement planning became more difficult, and more important, when defined benefit plans began disappearing. At one time as many as 40% of American workers were covered by defined benefit plans which were, in essence, a guaranteed retirement income plan. As long as a person remained employed, these plans provided a high degree of predictability and security.

When these plans were replaced by defined contribution plans, such as 401(k) plans, the responsibility for retirement income shifted to the individual. The amount of income that can be generated from a defined contribution plan is now based solely on the level of contributions made and the rate of return earned.

So, now proper retirement planning requires making sound and reasonable assumptions about how much one can save and what the expected rate of return on savings will be over time. It also requires that careful attention be given to retirement income needs based on a desired lifestyle. Assumptions, goals and needs must be realistic and the retirement plan must be reviewed regularly in order to make adjustments as changing financial circumstances dictate.

For most people, their retirement savings account will be their only source of income outside of Social Security. While Social Security does provide a minimal safety net, the more prudent planning approach is exclude it when planning your income needs so that your Social Security payments become an income cushion. Plus, if you are able to delay your Social Security payments until age 70, your payments will be much higher.
The tax code provides all retirement savers with a number of incentives to save early and save a lot. All workers have access to a qualified retirement plan. Most employees have access to an employer sponsored plan, such as a 401k or a SIMPLE IRA. And, workers not covered by an employer plan can set up an IRA. Most of the plans allow contributions to be made using pre-tax dollars, and the earnings in the plans are allowed to grow tax deferred. A Roth IRA takes after-tax contributions, but the withdrawals at retirement are tax free. It should be the goal of every worker to maximize their contribution to these plans to take full advantage of the tax benefits while accumulating their primary retirement income source.

With the loss of defined benefit plans, the predictability and security of retirement plans have been lost. One of the obvious solutions is to save as much as you can in your retirement plans and plan your future using sound assumptions for investment growth, inflation and your income needs. Still, with the responsibility now squarely on the shoulders of individuals to provide their income, anxieties can run high, especially when the markets take their wild swings as they have in the past.

To inject a greater degree of predictability and security in their retirement plans, many people are adding annuities to their investment portfolio. The unique characteristics of annuities can give people the same degree of predictability and security as did defined benefit pension plans. Annuities can accomplish this in two ways: During the accumulation phase, annuities can provide guaranteed returns and preserve principal; and during the income phase, annuities can provide a guaranteed stream of income that cannot be outlived.

Investors don’t have to sacrifice good returns on their investment for this increased security. There are different types of annuities that can suit the varied investment preferences and risk tolerance of most investors. Fixed annuities offer guaranteed fixed rates of return with minimum rate guarantees. Indexed annuities offer the opportunity to generate rates of return tied to the gains in a stock index without downside risk. And, variable annuities enable investors to invest as they would in their 401k plans choosing from among various stock and bond investment accounts. While variable annuities do entail market risk, many of them include an option for earning a minimum rate of return should the market decline.

So, annuities can add stability to an investment portfolio during the accumulation phase. It is in the income phase, at retirement, that annuities provide the greatest degree of predictability and security. When income is desired, all annuities can be converted to a guaranteed stream of income. Most annuities include inflation protection riders that ensure that your income will retain its purchasing power.

A retirement planning strategy should include building a diversified portfolio of investments that, working together, reflects your investment objectives, priorities, preferences and risk tolerance. It is important to invest for growth while maintaining some stability in your portfolio so that it is not completely exposed to the risks associated with anyone type of asset.

Annuities, with their predictability, rate guarantees and principal protection, can be one of the better portfolio stabilizers. Then, when it is needed the most, at your retirement, annuities can provide the ultimate security of a guaranteed income stream that cannot be outlived. While they may not be right for everybody, all serious retirement planners should give annuities careful consideration for their retirement income strategy.