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The Indexed Annuity

An indexed annuity, sometimes referred to as an equity-index annuity, is a contract between you and an insurance company in which the issuing company promises to pay a minimum income to you for a set period of for your lifetime. Like other types of annuities, an indexed annuity can be immediate or deferred, meaning income starts either now or a date in the future. What makes an indexed annuity different from its counterparts, fixed and variable annuities, is how the return on the money within the annuity is generated.

How an Indexed Annuity Works

Indexed annuities are often described as the best of both worlds in the annuity universe, or as a middle ground between fixed and variable annuities. But it is important to recognize that indexed annuities are simply more complex fixed annuities. Here’s how they work.

Like other annuities, an indexed annuity is established with a lump sum, or premium, paid by your as the contract owner. However, instead of those funds earning a fixed rate of return (like a fixed annuity) or tied to an investment account (like a variable annuity), an indexed annuity allows for growth potential through index investing with protection against market downturns.

Understanding Indexing

Index investment means all or a portion of the funds within an indexed annuity connect to the value of an index, like the S&P 500. The insurance company tracks that index over time and then credits your account based on changes to that index. When the index tracked is up, your account is credited up to a specified limit; when the index is down, your account value does not decrease because protection of the principal balance is in place. The downside protection, not the potential for investment returns, is the main draw for utilizing indexed annuities.

Principal protection is the most common use for indexed annuities due to the cap rate involved with index investing. Within an indexed annuity, investment returns tied to the index have a cap rate. This is the maximum amount the investment may earn in a given timeframe. As an example, a cap rate for an indexed annuity may be set at 4%, meaning even if the index generated a 10% return, the maximum you would receive credited to your account is the 4% cap rate.

In addition to the cap rate, indexed annuities may also have what’s known as a participation rate. The participation rate is the percentage of the index’s return the issuing company credits to your indexed annuity balance. For example, if the market generated the same 10% as above and the insurance company’s participation rate was 80%, your account would be credited 8% or 80% of the return. However, most indexed annuities that have participation rates also have cap rates – typically the lower rate applies.

Each indexed annuity differs from the next in terms of cap rate and participation rate, but they may also vary in how often those rates come into play. Some insurance companies credit indexed annuity accounts each month while others opt for a quarterly or annual schedule. These differences can have a significant impact on your overall return over time.

Benefits of an Indexed Annuity

The most obvious benefit to an index annuity is the downside protection it offers to investors and savers. Even when the broad market is declining, you have some peace of mind that, while not earning, your indexed annuity balance is not going down. You also have the potential to earn more when the market is rising, up to the contract limits mentioned above.

Some indexed annuities also provide a guaranteed minimum income in the future when a rider, or contract enhancement, is added. Like other types of annuities, indexed annuities are meant to be a vehicle that generates a stream of income that you cannot outlive. With the right features attached to the contract, an indexed annuity provides that over time.

Caveats to Indexed Annuities

Although indexed annuities work as a sort of middle ground between fixed and variable annuities regarding risk and return, there are drawbacks. First, indexed annuities can be complex because of the cap and participation rates, crediting schedules, and riders available from a myriad of insurance companies. Not fully understanding these differences may lead to establishing an indexed annuity contract that does not adequately meet your retirement savings needs.

Above and beyond complexity, indexed annuities can be costly over the long run. Insurance companies typically offer indexed annuities with a surrender schedule. This means that a certain percentage is withheld as a penalty in the first few to several years of the contract should you decide to move your funds to another account. Also, indexed annuities may carry annual fees, typically charged as a percentage of the total account balance. Adding riders to the contract may increase these fees, which ultimately eat away at your return.

Indexed annuities also have relatively low cap and participation rates, making them less appealing to investors or savers who are seeking to generate a market-like return. Keep in mind that indexed annuities were initially designed to compete with certificates of deposit – not stock market portfolios – and so they are often more appropriate for conservative investors.

Indexed annuities can be a helpful tool in progressing toward your retirement savings goal, or generating income during your retirement years. However, it is necessary to understand how indexed annuities work, including return limitations and fees, before adding a contract into your retirement planning mix.


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