An index annuity is an annuity whose rate of return is based
on a market index, such as the S&P 500 or the Nasdaq 100. Unlike most
variable annuities, an indexed annuity sets limits on your potential gains and losses,
so these annuity contracts are less risky than investing directly in the market
but also have less upside.
How Does an Index Annuity Work?
Like most annuities, index annuities can provide you with a
steady stream of income in retirement. Before you start receiving any income,
though, you must first agree to and fund a contract. Your contract will spell
out how you will fund your annuity—all at once with a lump sum or with steady
payments over time—and when you can begin to make withdrawals.
The annuity company will invest your money using the index
you select. The exact indexes available depend on the annuity company, but
common indexes include the S&P 500, the Nasdaq 100, the Russell 2000 and
the Euro Stoxx 50. You can put all your money in one index or split it across
several.
Equity indexed annuities may be safer than investing
directly in index funds because the annuity company protects you against
losses. That, of course, comes with the tradeoff that you won’t earn the same
high returns that an index fund outside of an annuity might have.
Index annuities also benefit from tax-advantaged status,
similar to 401(k)s or IRAs. This means your investment returns will grow
tax-deferred until you withdraw them.
Index Annuity Returns
The amount your indexed annuity earns is based on the
underlying index. Let’s say you buy an S&P 500 index annuity. When that
market goes up, you make more money, but when the market goes down, you earn
less and may even lose money. The long-term annual average rate of return for
the S&P 500 is about 10%. But you won’t see quite that return on your
investment.
Index annuities don’t pay out the exact return of the index.
Instead, they use a system to limit both your potential losses and your
potential gains. That’s why this product is also called a fixed index
annuity—because your losses and gains fall within a fixed limit. These limits
are normally set using a combination of the following:
Minimum guaranteed return. The annuity company could
guarantee a baseline minimum return each year, even if the underlying index loses
money. For example, it might pay 1% even if your target index has a negative
return for the year.
Loss floor. Your contract may also include a loss floor,
which is the most you could lose in a market downturn. A contract might set
your floor at 10%, which means 10% would be the most of your deposit you could
lose from market losses.
Adjusted value. Your index annuity may lock in your gains
periodically. In other words, if your balance goes up, the annuity company
could guarantee that it would not fall below that new adjusted value, even if
the index loses money in the future.
Return caps. On the other end, the annuity company might set
a maximum possible return per year. For example, the most you could earn might
be 6% per year, even if the underlying index earns more.
Participation rate. Participation rate describes the
percentage of index returns that the annuity will pay. If your participation
rate was 70%, you would only receive 70% of the index gains. If the index went
up 10%, you’d receive 7% (10% x 70%).
Spread/margin/asset fees. The annuity company may deduct a
fee from the index return. If its fee were 4% and the index returned 10%, your
gain would be 6% (10% minus 4%).
Your actual index annuity could contain any combination of
these caps and fees. Accounting for various caps and participation rates,
annuity market research company Cannex estimated in 2018 that over seven years
an index annuity might yield 3.26% on average annually. That said, rates of
returns will greatly vary based on the stipulations of your annuity contract.
Index Annuity Withdrawals
Besides growing your savings, one of the appeals of an index
annuity is the income it can generate for you. Index annuity payments can last
over a set number of years or can be guaranteed for your entire life, depending
on your contract. Like most tax-advantaged retirement accounts, investment
gains are taxed upon withdrawal.
Payments for index annuities are classified in two main
ways: An immediate annuity starts paying money back to you within a year of you
signing up. A deferred annuity, on the other hand, holds onto your money for at
least a year before distributing payments. The longer you wait, the more the
index annuity will grow your balance and therefore the greater potential future
payments you’ll have.
Early Index Annuity Withdrawals
If you need to make an unexpected large withdrawal, you
can—but it may cost you. Any payment from an annuity is taxed, and, depending
on how long you’ve held your annuity, you could be subject to a surrender penalty
that costs about 7% of your withdrawal.
The surrender period typically lasts between five to seven
years as index annuities are considered long-term investments. If you need to
make a large withdrawal from your annuity before age 59 ½, you may also incur a
10% penalty from the IRS.
Index Annuity Costs
After you purchase an index annuity, your annuity company
deducts several charges from your balance and your investment earnings each
year:
Return limits. Whether the annuity company uses a return cap,
a participation rate, a spread/margin/asset fees, or any combination of the
above, it will be keeping part of the index investment return.
Mortality and expense fees (M&E fees). Annuities charge
M&E fees to cover the future income they guarantee. Part of this cost may
also go towards the commission of the agent who sold you the contract.
Administrative expenses. The annuity may charge an administration
fee for managing the contract.
Rider fees. Riders are extra benefits you can purchase for
the annuity. For example, you could buy a rider that guarantees a minimum level
of monthly income in the future, no matter how badly the index investment performs.
You need to pay an extra annual fee for each rider.
Surrender charge. Your index annuity might have a surrender
period of between five and seven years—and possibly even longer. If you make a
lump sum withdrawal or cancel the contract before then, the annuity company
could charge a surrender fee of around 7% your balance. This fee may go down
over time. For example, a 7% surrender fee might drop a percentage point each
year until it’s gone.
Benefits of Index Annuities
Moderate return potential. By investing your money in stock
market indexes, an index annuity can have a decent long-term return,
potentially better than what’d you receive through a bank certificate of
deposit (CD), fixed annuities and savings accounts.
Protection against market losses. The index annuity protects
your savings against losses, making it a relatively safe investment. You get
some market upside with less of the risk.
Potential preservation of market gains. Your contract could
lock in your gains periodically, like once a year. That way you don’t have to
worry about future market downturns erasing your earnings.
Inflation protection. The historic long-term return of the
stock market is higher than inflation, so index annuities can protect the
future buying power of your savings.
Drawbacks of Index Annuities
Limit on gains. Index annuities do not have the same upside
as if you invested in the market directly or if you invested in a variable
annuity because the annuity company caps your potential gains.
Complicated contract language and regulations. Given their
various caps and participation rates, figuring out your return and other
features can be complicated. Fixed annuities are generally much easier to
understand.
High fees. Index annuities charge a number of fees. These
can cost you more than if you invested through index funds on your own through
a retirement plan or a brokerage account, though those options don’t offer the
loss protection of index annuities.
Unpredictable return. Your index annuity return ultimately
depends on the performance of the index. If there’s a bad market stretch, you
might earn very little compared to accounts that pay a guaranteed annual
return.
Index Annuity vs. Variable Annuity
Like an index annuity, a variable annuity also puts your
money in stock market funds and indexes. It doesn’t, however, include the same
limits on gains and losses as an index annuity. This grants you the potential
for higher gains but also higher losses.
If you’re investing for the long-term and can handle waiting
out market swings, you could potentially earn more with a variable annuity. An
index annuity is better if you want some market exposure without the chance of
a big loss, even if it means not earning as much in good years.
Index Annuity vs. Fixed Annuity
A fixed annuity pays a set return each year that’s partially
guaranteed by the annuity company. It’s more like a bank CD or a savings
account because you can predict how your money will grow without worrying about
what’s going on in the stock market. This certainty, however, comes at a cost:
In the long-run, a fixed annuity will likely earn less than an indexed annuity.
If you have a short-term goal or just want to grow your
money by a definite amount, a fixed annuity could be a good choice. If you want
more growth and don’t mind a little more short-term unpredictability, an
indexed annuity could be better.
Who Is an Indexed Annuity Good For?
An indexed annuity is best for someone who wants to invest
the stock market but is worried about losses. With these contracts, you get
some market upside without having to worry about a bad downswing. Index
annuities are also a better choice for medium and long-term savings goals. This
way you can wait out a temporary market downturn so that you can then earn
higher long-term index returns.
For short-term goals or situations where you absolutely need
some earnings over the next few years, you may be better off with something
that offers more of a guaranteed return, like a fixed annuity or a CD. On the
other end, if you want the highest possible return and don’t mind more risk,
you could potentially earn even more with variable annuity or a direct
investment in the stock market.
Indexed annuities are some of the more complicated
investment products out there. If you need help understanding the terms,
consider meeting with a fee-only financial advisor to determine what, if any,
kind of annuity is right for you.
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