These features are common to all index annuities:
- Variable, index-linked yield
- Participation rate
- Minimum guaranteed rate
All indexed annuities track the performance of a stock market bellwether. The S&P 500 is a common index that represents the U.S. stock market at large. 500 companies from across different sectors and industries are meant to provide a random sample of the entire market. An index annuity linked to the S&P 500 returns a rate directly proportional to how well the S&P 500 performs during a given year.
Although the S&P 500 is the most popularly tracked index, others may be used, like the Russell 2000, NASDAQ, and Dow Jones Industrial Average. Regardless of which index your annuity tracks, it’s important to realize that your account’s GROWTH is tied to the overall well-being of the market. This is different from a variable annuity, in which your captial is tied the preformance of individual stock, and you stand to lose principle.
The participation rate is the percentage of an index’s growth that’s credited to the annuity owner’s account, and it’s typically below 90% — it’s the reason the insurance company can protect you from losing capital when the market plummets.
Consider this example: John invests $50,000 in a index annuity linked to the S&P 500 with a 70% participation rate. Over the next year the S&P 500 experiences an 10% growth. John’s account is credited with 70% of that 10% growth, leaving him with a total of $53,500. If John had invested in the S&P 500 directly, his account would be worth $55,000.
Looking at one year in isolation makes it seem as though John made a bad investment. Actually, he’s strategically opted to share a portion of his winings in return for secruity during the inevitable bad years. John has insured himself against losses.
Minimum Guaranteed Rate
Every index annuity features a minimum rate of return regardless of index performance. This rate is the insurance, and it varies from contract to contract from 1-3%. The minimum rate guarantees that whenever the index decreases in value, you’re earning as least a bit.
Savvy investors practice capital preservation. Why? Because on average 1 in every 4 years is negative. When you’re in the market for the long run your average growth is heavily affected by losses during that negative year. Anything you can do to minimize those loses is smart investing. In this light, the minimum rate is very appealing because it prevents the erosion of pervious years’ gains.
Index annuities are tax-deferred. This, and their diminished liquidity make index annuities a deferred investment vehicle, perfect for retirement savings. Your account can accumulate value tax-free, indefinitely, until income is cashed out. Under normal circumstances you would delay cashing out as long as possible to earn compound interest on what would have been the government’s money had you invested in a CD or mutual fund.
Most index annuities are single-premium contracts, meaning that you buy-in with one up front payment. As with a fixed annuity, after the contract is written, no further investment is allowed. This isn’t too limiting, however, as the insurance company will always be happy to start a fresh contract with up-to-date rates.
Why does the insurer limit deposits? Quite simply to prevent investors from taking advantage of the locked-in guarantees. It would clearly be in your favour to make additional deposits during negative years because the insurance company would take the hit and you’d put yourself in a great position for the rebound.
That said, a minority of the index annuities offered today feature flexible-premiums, allowing investors to keep funding their accounts indefinitely. This benefit is typically counter-balanced by an administration fee and lower participation rate.