What is an Indexed Annuity

Like all annuities, an indexed annuity is a financial contract between an investor and an insurance company. When an investor purchases an indexed annuity, he or she is obligated to leave the money in the annuity for the length of the contract. The issuer is then obligated to make payments as outlined in the terms of the contract.

The rate of return paid by the issuer is tied to a financial market index, most often the Standard & Poor’s 500 Composite Stock Price Index (S&P 500). The S&P 500 is a diverse representation of almost all industry segments in the United States. If the index to which the annuity is tied increases in value, the annuitant, or owner of the contract, is paid a portion of the gains. If the index decreases, he or she is generally protected from suffering significant losses as most issuers guarantee the principle of an indexed annuity.

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How Does an Indexed Annuity Work

An indexed annuity is most often purchased for retirement savings. A lump sum investment, also known as a single premium, is typically used to purchase the contract. Indexed annuities are considered low risk investments because most issuers guarantee the principle and the previous gains that have been credited to the annuity.

A number of factors can affect the return paid on an indexed annuity. These include the participation rate, an interest rate cap, and the administration fee:

The Participation Rate

This rate figures the amount of the increase in the underlying index that will be paid. In other words, it figures the percentage of the index’s increase that the annuity contract participates in. For example, if the participation rate is 80% and the S&P 500 increases 2%, the amount credited to the annuity would be 1.6%. (The participation rate is figured by multiplying the increase of the index, 80% x 2%.) Participation rates vary, but are most often between 70% and 90%.

Interest Rate Cap

Some indexed annuity contracts set a maximum rate that will be paid regardless of how much the index increases over a period of time. For example, if the maximum rate were capped at 6%, only 6% would be credited to the annuity even if the market to which it is tied were to increase by 9%.

Administration Fee

Some insurance companies charge administrative fees for their services in managing the contract. This amount, usually a percentage, is also deducted from the total amount credited to the account. While some insurance companies offer no-load and no surrender charge annuities that can be less expensive to purchase, these types of contracts still charge management and mortality and expense fees. 

Crediting Methods

While the interest rate cap and administration fee are fairly straightforward, the participation rate is more complicated. There are three ways in which insurance companies calculate the percentage increase in the index to determine the participation rate: The annual reset method, the high water mark method, or the point-to-point method.

The Annual Reset or Rachet

This method looks at the percentage change in the index from the beginning of the contract year to the end of the contract year, each and every year of the contract. The advantage of this method is that gains are locked in each year, which can be beneficial if the index is lower at the end of the year than it was at the beginning. The disadvantage is that combined with a lower interest cap rate or participation rate, the amount of interest gained may be limited.

The High Water Mark

This method reviews the value of the index to which the annuity is tied at several points during the year and uses the highest point as the comparison at the start of the next term. The advantage is that more interest may be credited than other indexing methods. The disadvantage is that interest is not credited until the term’s end, and, like the annual reset method, can be combined with a lower interest cap rate or participation rate.

The Point-to-Point

The point-to-point method looks at the change in the index at two specific points during the contract term, usually at the beginning and the end. The advantage of the point-to-point method is that combined with a higher interest cap rate and participation rate, more interest may be earned. The disadvantage is that interest earned is based on a point that can be significantly lower than any other point throughout the term.

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Who Should Invest In an Indexed Annuity

Indexed annuities are usually best for the investor with long-term savings goals or who is looking to save for retirement. They can also be good for a high net-worth investor or one who has maxed out other tax-free retirement vehicles such as a 401(k) or IRA. They are also appropriate for an investor who wants to guarantee a stream of income for a defined period of time.

How Does an Indexed Annuity Compare to a Fixed Annuity and to a Variable Annuity?
An indexed annuity differs from a fixed and variable annuity in the way that the rate of return is calculated and credited to the account:

Indexed Annuity

The rate of return is variable and based on the performance of the index to which it is tied.

Variable Annuity

The rate of return is variable and based on the performance of the stock and/or bond mutual funds and money market funds in which the annuitant’s chooses his or her money to be invested.

Fixed Annuity

The rate of return is set at a fixed amount, regardless of the performance of a particular index or stock and/or bond mutual funds and money market funds.

What are the Benefits of an Indexed Annuity

Investors looking for long-term growth may find that over time, indexed annuities out-perform several other types of investments with the same risk-reward potential. Unlike other investment vehicles, they do not expose an investor to extreme market risk, but they may not provide significant growth in a low interest rate environment.

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