This series of articles describes the three different types of annuities available for retirement savings, Fixed Annuities, Variable Annuities and Indexed Annuities. In Part 1 of the series we described the first type, Fixed Annuities. In Part 2, we covered Variable Annuities. In this article, Part 3 of this series, we answer the question, What is an Indexed Annuity?
To quickly review the basics, all annuities are designed to generate income in retirement through tax-deferred investing. Every annuity provides guaranteed payments made at regular intervals, either for a specific number of years or for the rest of your life. When you receive payments from an annuity, starting any time after age 59 ½, you pay taxes only on the portion of those payments that comes from investment income. Annuities are provided by insurance companies, who guarantee the payments for the life of the contract. Beyond that, there are big differences between Fixed, Variable and Indexed Annuities.
What is an indexed annuity?
An indexed annuity, as the name suggests, is an annuity that provides an investment return linked to a stock market index. The index is typically the S&P 500, which tracks the returns on a portfolio of stocks of large U.S. corporations. An indexed annuity earns a percentage of the return on the index. This “participation rate” can be as high as 100%, or as low as 25%, although most indexed annuities offer investors 80%-90% of the S&P 500 index’s return. Some indexed annuities offer a higher percentage of the index return for the first few years, and a lower percentage thereafter. For example, an indexed annuity might earn 95% of the return on the S&P 500 index for two years, then 80% of the index return after that.
When the stock market has a positive return, indexed annuity holders receive less than what investors would earn by simply buying a mutual fund or ETF that tracks the same index. However, even in years when the stock index declines, your annuity will earn minimum rate of return. A typical minimum rate guarantee is about 2%, but could be as low as zero, and perhaps as high as 3% percent. And, an indexed annuity guarantees the annuity holder will not lose any principal, whereas investing directly in a mutual fund or ETF has no such guarantee.
Most indexed annuities include a “cap” on the return credited to the annuity holder in a given year. For example, an 8% rate cap means the maximum return the annuity can earn in a single year is 8%, even if the stock market index goes up by much more than that. Rate caps can cover a broad range and often depend on the length of the annuity payout period.
Indexing Methods. There are a number of methods used to calculate the change in the relevant index over a given period. This can have a big impact on the return “credited” to the annuity, so be sure you understand what method a contract uses before you sign:
- The annual reset – perhaps the most familiar method, this approach uses the percentage change in the value of the index, measured at the beginning and end of the year.
- High water mark – this method compares the highest level of the index during a period, often one year based on the anniversary date of the annuity contract, to the value of the index at the beginning of the period. This may sound like it offers the highest return possible, but is often combined with a cap that limits the return.
- Point to point – with this approach, the index return is measured at the beginning and the end of a specific period, which could be two years, three years, or even the entire period between the start of the contract and the date you start receiving payments. This method could be beneficial if it “jumps over” a year that would have generated a low return, but it could also be bad if the index value at the ending date of the period happens to fall during a multi-year low point for the market.
How do indexed annuities compare to the other types of annuities?
An indexed annuity provides the opportunity to earn more than a fixed annuity through its stock market-based returns, although a fixed annuity can earn more in some years, especially when the market declines. Indexed annuities and variable annuities both offer investors exposure to the stock market, but with variable annuities the annuity holder chooses his or her own combination of mutual funds covering different markets that can include both stocks and bonds, whereas an indexed annuity is linked exclusively to the U.S. stock market.
There are details about Indexed annuities, as well as Fixed and Variable annuities, that are important to know before you move forward so be ready to go over the fine print before you decide which type of annuity is right for you.