Lesson in Indexed Annuities Part 1

As we plan for our retirements, there are many financial instruments at our disposal. In addition to savings plans, employer‐matched retirement savings programs, and Individual Retirement Accounts (IRAs), annuities are a great option. There are several types of annuities; here, we’ll discuss indexed annuities and the factors influencing them.

View the full presentation here.

What is an Annuity?

In simple terms, an annuity is simply a savings plan over the long term. Annuities are a form of an insurance contract and is used to accumulate financial assets on a tax‐deferred basis. These annuities can also be used to convert any assets accumulated for retirement into a stream of income. Typically, there are two major phases and two primary types of annuities, each depending on the needs of each individual who is planning for retirement. Annuity types are chosen based on whether the individual needs to accumulate financial assets in preparation for retirement or if the individual is nearing retirement age and desires the creation of retirement income based on those accumulated assets. This “accumulation vs. income” model defines the phases of annuities, and each phase plays a role in the type of annuity.
The two types of annuities are Deferred or Immediate Income. In a deferred annuity, both phases come into play. During the accumulation phase, the individual contributes monetary premiums to the plan, where they accrue on a tax‐deferred basis. When it is time to implement the income phase, the total value of the accumulated assets is converted into regular income payments.
In an immediate income annuity, on the other hand, the annuity is funded with a single premium payment. Income payments to the individual begin immediately or within a short time after paying the initial premium.

More Annuity Choices

Before discussing indexed annuities, it can be useful to understand how annuities are invested. Depending on the individual’s tolerance for risk and the financial objectives of that individual, one may choose to invest annuity premiums in three types of accounts:

  • Fixed Interest Annuities
  • Variable Annuities
  • Indexed Annuities

Fixed interest annuities work just as the name suggests: the annuity pays a fixed rate of interest on the financial premiums invested into the annuity contract. The insurance company issuing the annuity agrees to pay a minimum interest rate for the life of the contract. There may also be bonus rates or excess rates paid to the individual, but contracts with these bonuses may also incur higher fees, reducing or even negating the value of the bonus interest rates paid.
A variable annuity, on the other hand, brings both accumulation and income phases come into play once again. During the accumulation phase, the premiums paid into the annuity are placed into a separate account by the issuing insurance company. In this account, the owner of the account may invest those premiums into one or more subaccounts, such as stocks and bonds.

Then, in the income phase, the income payments made to the account owner may be fixed or may be variable, depending on the language of the annuity contract. The variable rates are influenced by the value of the assets in the separate account created during the accumulation phase.

Indexed Annuities

Finally, we have arrived at indexed annuities. Here, an indexed annuity has characteristics of both fixed income and variable annuities; it is valuable to think of these annuities as the best of both worlds. In a similar fashion to a variable annuity, an indexed annuity pays a specific rate of return that is based on one of the major stock market index, such as Standard & Poor’s Composite Stock Price Index or the Financial Times Stock Exchange 100 Index, to name but a few. Also, in a similar way to fixed income annuities, the indexed annuity provides a minimum guaranteed interest rate. This gives indexed annuities a lower market risk than traditional variable annuities. Another benefit of indexed accounts is that they have a greater potential for higher earnings, especially as compared to fixed income accounts, as their interest rate is tied to a specific stock market index; if that index rises in overall value, the indexed annuity does as well.
It is critical to understand some of the drawbacks of an indexed annuity, however. First, an individual could lose some or all of the value of the assets in the account if
The issuing insurance company does not guarantee 100% of the principal; You receive no interest linked to the stock market index due to a decline in the stock market; You surrender the indexed annuity while a surrender charge is in effect.
A surrender charge is basically a deferred sales fee imposed by the issuing insurance company and is tied to the period of time an investor must wait before withdrawing any assets without penalties. In most indexed annuities, the insurance company sets a long surrender period, with a surrender charge usually equal to a percentage of any assets withdrawn. In addition to the surrender period and charges associated with that period, there may also be withdrawal tax penalties if certain conditions are not met. Any withdrawals made by the account holder before he or she reaches the age of 59 ½ may be subject to a penalty tax, typically at 10%.
In next installments of our indexed annuities blog series, we will discuss more of the details surrounding these retirement savings strategies, how they work, and how they can enhance the retirement planning process. Stay tuned for more.

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