What is an Indexed Annuity?

Can you get both principal safety and potential investment gain? Indexed annuities offer a similar promise but it is important to understand how these products work before buying.

About Indexed Annuity

An indexed annuity is a financial product that pays returns based on the performance of a linked index. The contract is backed by an insurance company and is popular with retirees because it provides a relatively steady stream of income with downside risk protection. However, it also severely limits the upside potential of investment by reflecting the trade-off between risk and return.

How Indexed Annuities Work?

Indexed annuities offer their owners, or annuitants, the opportunity to earn higher yields than fixed annuities when financial markets perform well. In general, they also provide some protection against market declines.

The rate on an indexed annuity is computed depending on the year-over-year gain in the index or its average monthly return over a 12-month period.

While an indexed annuity is linked to the performance of a particular index, the annuity does not necessarily receive the full benefit of any increase in that index. One cause is that indexed annuities frequently cap the possible benefit at a specific percentage, generally called the “participation rate.” The participation rate can be as much as 100%, indicating all profits are deposited into the account, or as down as 25%. Most indexed annuities offer participation rates between 80% and 90%—at least in the early years of the contract.

If the stock index rose 15%, for example, an 80% participation rate translates into a credit yield of 12%. Multiple indexed annuities provide a high participation rate for the first year or two, after which the rate alters the downside.

Index Annuity Returns

The amount your indexed annuity earns depends on the underlying index.

Suppose you buy an S&P 500 index annuity. When that market goes up, you earn more, but when the market goes down, you earn less and may even lose money. The long-term average annual rate of return for the S&P 500 is about 10%. But you won’t see that much return on your investment.

An index annuity does not pay the exact return of the index. Rather, they utilize a system to limit both your possible losses and your possible returns. That’s why this product is also called a fixed index annuity – because your losses and profits come within a fixed limit. These limits are usually set using a combination of the following:

• Minimum Guaranteed Return: An annuity company can guarantee a baseline minimum return every year, even if the underlying index loses money. For example, your target may pay 1% even if it has a negative return for the year.
  
  
• Loss floor: Your contract may also include a loss floor, which is the most you can lose in a market downturn. The contract may set your floor at 10%, which means that 10% of your deposit will be the most you can lose to market losses.
  
  
• Adjusted value: Your index annuity can lock in your profits over time. In other words, if your balance increases, the annuity company can guarantee that it will not fall below the new adjusted value, even if the index loses money in the future.
  
  
• Return caps: On the other hand, an annuity company can set a maximum possible return per year. For example, the most you can earn might be 6% per year, even if the underlying index earns more.
  
  
• Participation Rate: The participation rate describes the percentage of the index return that the annuity will pay. If your participation rate was 70%, you would get only 70% of the index benefit. If the index rises by 10%, you will receive 7% (10% x 70%).
  
  
• Spread/Margin/Asset Fee: The annuity company may deduct the fee from the index return. If its fees were 4% and the index returned 10%, your gain would be 6% (10% minus 4%).

Your actual index annuity may contain any combination of these caps and fees. Accounting for different caps and participation rates, annuity market research company Cannex estimated in 2018 that an index annuity could yield an average annual yield of 3.26% over seven years. That said, rates of return will vary greatly depending on the terms of your annuity contract.

Index Annuity Withdrawals

In addition to increasing your savings, one of the appeals of an index annuity is the income it can generate for you. Index annuity payments can last for a number of years or be guaranteed for your entire life, depending on your contract. As with most tax-advantaged retirement accounts, investment gains are taxed on withdrawals.

Payments for an index annuity are classified in two main ways: Immediate annuities start paying you back within a year of signing up. Deferred annuities, on the other hand, hold your money for at least one year before distributing payments. The longer you wait, the more the index annuity will add to your balance and therefore the more potential future payments you will have.

Early Index Annuity Withdrawals

If you need an unexpected large withdrawal, you can—but it could cost you. Any payouts from the annuity are taxed, and, depending on how long you’ve held your annuity, you may be subject to a surrender penalty that costs around 7% of your withdrawals.

The surrender period is typically five to seven years as index annuities are considered long-term investments. If you need to withdraw large amounts from your annuity before age 59 ½, you may also incur a 10% penalty from the IRS.

Index Annuity Costs

After you buy an index annuity, your annuity company deducts certain fees from your balance and your investment earnings each year:

• Return Cap: Whether an annuity company uses a return cap, participation rate, spread/margin/asset fee, or any combination of the above, it will retain a portion of the index investment return.
  
  
• Mortality and Expense Fee (M&E Fee): Annuities charge an M&E fee to cover the future income they guarantee. A portion of this cost may also go to the commission of the agent who sold you the contract.
  
  
  
• Administrative Costs: Annuity may charge an administrative fee to administer the contract.
  
  
• Rider Fees: Riders are additional benefits that you can buy for an annuity. For example, you can buy a rider that guarantees a minimum level of monthly income in the future, no matter how poorly the index investment performs. You need to pay an additional annual fee for each rider.
  
  
• Surrender charge: The surrender period of your index annuity can be between five and seven years—and possibly longer. If you withdraw the lump sum or cancel the contract before then, the annuity company may charge a surrender fee of around 7% of your balance. This fee may decrease over time. For example, a 7% surrender fee might fall a percentage point every year until it’s gone.

Benefits of Index Annuities

• Moderate return potential: By investing your money in stock market indices, index annuities can yield decent long-term returns, potentially better than what you would get from bank certificates of deposit (CD), fixed annuities, and savings accounts.
  
  
• Protection against market losses: Index annuities protect your savings against losses, making them a relatively safe investment. You get some market upside with less risk.
  
  
• Potential Retention of Market Profits: Your contract may lock in your profits over a period of time, such as once a year. That way you don’t have to worry about a future market downturn wiping out your earnings.
  
  
• Inflation Protection: The stock market’s historical long-term returns outpace inflation, so index annuities can protect the future purchasing power of your savings.

Drawbacks of Index Annuities

• Limits on gains: Index annuities do not have the same upside as if you invested directly in the market or if you invested in a variable annuity because the annuity company limits your potential gains.
  
  
• Complex contract language and regulations: Given their different caps and participation rates, estimating your compensation and other benefits can be complicated. Fixed annuities are generally pretty easy to understand.
  
  
• Multiple fees: Index annuities levy multiple fees. This can cost you more than if you invested in an index fund on your own through a retirement plan or brokerage account, although those options don’t protect against the losses of index annuities.
  
  
• Unpredictable returns: Your index annuity returns ultimately depend on the performance of the index. If the market conditions are bad, you can earn very less compared to accounts that pay guaranteed annual returns.

Index Annuity vs. Variable Annuity

Like index annuities, variable annuities also invest your money in stock market funds and indexes. However, it does not include the same limitation of profit and loss as an index annuity. This gives you higher profit as well as higher loss potential.

If you’re investing for the long term and can handle waiting out market swings, you can potentially earn more with a variable annuity. An index annuity is better if you want market exposure without the possibility of big losses, even if it means not earning as much in the good years.

Index Annuity vs. Fixed Annuity

A fixed annuity pays a set return each year that is partially guaranteed by the annuity company. It’s more like a bank CD or savings account because you can predict how your money will grow without worrying about what’s going on in the stock market. This certainty, however, comes at a cost: In the long run, fixed annuities will earn less than indexed annuities.

If you have a short-term goal or just want to grow your money by a certain amount, a fixed annuity can be a good choice. If you want more growth and don’t mind a little more short-term unpredictability, indexed annuities may be better.

Who should go for an Indexed Annuity?

An indexed annuity is best for someone who wants to invest in the stock market but is worried about losses. With these contracts, you get some market upside without worrying about a nasty downswing. Index annuities are also a more suitable option for medium and long-term savings plans. This way you can wait out a temporary market downturn so that you can reap long-term index returns.

For short-term goals or situations where you need some income over the next few years, you may be better off with something that offers a more guaranteed return, such as a fixed annuity or CD. On the other hand, if you want the highest possible return and don’t mind high risk, you can potentially earn more with a variable annuity or direct investment in the stock market.

Conclusion

An indexed annuity is not just a variable annuity with minimal guarantees. It’s more complicated than that. However, the mixed nature of the investment vehicle still keeps it attractive to relatively aggressive investors looking for an annuity to help them fulfill their savings plans. They are also subject to the same pros and cons of annuities.

With an indexed annuity, it’s important to keep a clear eye on what you’re buying. You should not expect an attractive rate of return, as it may lead to disappointment. However, if you’re looking for a minimum rate guarantee and the potential for more, indexed annuities may be right for you. As always, be sure to know all the details of the contract with your insurer. Be aware of any caps, participation rates, or other fees that may eat into your compensation.

FAQs About Indexed Annuities