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
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.
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.
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.
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.