Equity Indexed Annuity Guide

An Overview

An equity indexed annuity is an insurance contract linked to a common market index, such as the S&P 500. If the index grows you’re entitled to a majority of the earnings. If the index declines, you’re account is protected against losses with a modest baseline rate.

Index annuities are a hybrid between fixed and variable annuities. They’re typically invested into with a single up front payment. Unlike fixed annuities, index annuity rates vary based on market performance, and unlike variable annuities, you’re typically covered against losses. Growth potential for index annuities is strong, averaging 10-15%, on up years, and 1-3% on down. Unlike variable annuities, index annuities allow you to participate in the market without ever risking principle.

Index Annuity Features

Index annuities vary, but generally feature:

  • Single Premium — Buy into the contract with a single lump-sum payment. Further investment typically requires additional contracts.
  • Invest in the Market — Linked to an index like the S&P 500. Equity indices outperform debt-based vehicles like CDs or bonds in the long-term.
  • Minimum Guaranteed Rate — No matter how much the market drops in a given year your account will grow at the 1-3% baseline rate.
  • Low Risk — Can’t lose principle. Money can only be lost if the insurer becomes insolvent and your investment exceeds state annuity insurance.
  • Good Growth — Ideal of investors looking for stock market growth and coverage against bad years. Good retirement vehicle.
  • Variable Returns — Annual rate of return varies based on index performance.
  • Hassle Free — No micro management. Sign the contract, pay the premium, start growing your nest egg.
  • Vesting Schedule — Withdraw earnings early without penalties up to certain amounts.
  • 1-10 Year Term — Index annuities are available for short, medium, or long terms.
  • Tax Deferral — Pay nothing on interest earned until you cashout. Earn interest on the IRS’s money.
  • Unlimited Contributions — Invest as much as you’d like tax-free without the IRS breathing down your neck. Beats 401(k) and IRA.
  • Life Insurance — Optional life insurance provision offers death benefits to loved ones. Save money on separate life policy.
  • Inheritance — Bequeath money to loved ones probate-free. Avoid estate/death taxes.
  • Tax-Free Gifts — Gift up to $10,000 per individual, per year, tax-free. Gift money to an unlimited number of individuals.

For more discussion on each feature, read: Index Annuity Features.

Index Annuity Performance

In looking at historical data, index annuities often out-perform investments that are traditionally thought-of as higher-yielding, and this they do without exposing investors to undue market risk. Over periods of 10-20 years, an index annuity is guaranteed to shield your money from economic turmoil while averaging 7-10% returns. To see how your index annuity would have out-performed the S&P 500 from 1998-2008, follow along to: Index Annuity Performance.

Finding the Best Index Annuities

A good index annuity shares the best features of fixed and variable contracts. But, index annuities come in several flavors, making comparison shopping difficult. Finding the best index annuity is a matter of weighing four key contract provisions: participation rate, cap rate, minimum rate, and administration fees. To learn how these factors intermix and which ones should be prioritized, see Finding the Best Index Annuity.

Fixed Index Annuity

A fixed index annuity offers the benefit of capital preservation and equity-based growth. This means you’ll spend less time worrying about your nest egg’s safety and grow your wealth faster. For an in-depth overview of how fixed index annuities work, and how they compare to traditional fixed or variable annuities, see the fixed index annuity page.

Index Annuity Disadvantages

Every investment vehicle has its own set of unique pros and cons. Index annuity disadvantages include: early withdrawal tax penalties, their ordinary income status, administration fees, withdrawal fees, their vesting schedules, and the single-premium nature of their contracts. If any of these factors are deal-breakers, a fixed or variable annuity might be a better alternative.

For an in-depth discussion of each index annuity disadvantage, see: Index Annuity Disadvantages.

Index Annuity Pitfalls

Navigating an index annuity contract can be tricky. As a result, nearly all common pitfalls occur from failure to read the sticking points. The most important provisions in any index annuity contract include: the participation rate, cap rate, minimum guaranteed rate, administration fees, and vesting schedule. You’ll want to familiarize yourself with these factors to understand how to spot the most favourable terms.

Avoid getting stung. Learn about the specific mistakes associated with each contract provision by reading, index annuity pitfalls.

Index Annuity Alternatives

Determining which investment vehicle best meets your savings goals is paramount. Index annuities are ideal for the “typical” retirement saver who’s looking for a compromise between the security of fixed annuities and the growth potential of variable annuities. To explore how index annuities stack up against non-annuity alternatives like CDs, bonds, IRAs, the S&P 500, and many others, see index annuity alternatives.

Who Should Buy Index Annuities

The diminished liquidity of index annuities make them well-suited as retirement instruments. Investors looking to capitalize on market growth can do so without risking loss of principle. Investors with a horizon of 5+ years are ideal candidates for index annuities.

Although your principle is guaranteed at all times, unlike with a fixed annuity, income is variable and cannot be easily calculated into the future. If you need a guaranteed income stream, consider a fixed annuity instead. If you’d like to fully capitalize on market growth at the expense of more risk, consider variable annuities.