Lesson in Indexed Annuities Part 2

In the first installment of our blog series on indexed annuities, we introduced the concept of these financial instruments. Our first lesson revolved around how they work, how account holders may choose to invest in them, and the different types of indexed annuities available to those planning for retirement.

In this part of our series, we’ll delve deeper into the world of indexed annuities. This will include the features of the annuities and some of the details of a typical indexed annuity contract. We will also discuss why an individual might choose such an annuity as a retirement account rather than or in addition to other asset accumulation strategies. Let’s get started. 

(If you would like to follow along with the entire presentation, please click here.)

Features of an Indexed Annuity

As we discussed earlier, indexed annuities have some of the features of the two other common annuities, fixed-interest, and variable annuity accounts.

The similarity with fixed interest annuities is that there is a minimum guaranteed interest rate set by the insurance company the contract is purchased from. The difference between indexed and fixed-interest annuities is that the guarantee does not provide for 100% of the premiums the account holder pays into the account. Typically, only 87.5% of premiums is guaranteed. It is also important to keep in mind that any early withdrawal or surrender of the account can result in the loss of interest earnings, principal, and the incursion of substantial tax penalties.

The primary similarity between an indexed annuity and a variable annuity is in the interest rate itself. Although there is a fixed MINIMUM guaranteed interest rate, the interest rate can increase based on the performance of the stock index the annuity is tied to. For example, an indexed annuity that follows the Standard & Poor 500 Composite Stock Price Index may rise in value as the Index value rises. This helps produce a greater rate of return for the account holder.

Interest Formulas and Caps

Remember that an indexed annuity is an insurance contract agreed to between the insurance company and the account holder. It is not a direct investment in the stock market, and the annuity performs differently than other investments. The issuing insurance company typically uses a formula to determine how interest is credited to the account holder. This formula will be contained in the legal language of the annuity contract and comes into play when interest payable in excess of the minimum guaranteed interest rate occurs. Some of the formula components include:

  • Indexing Methods – this refers to the various methods used to determine changes in the linked index over the period of the annuity contract. The indexing method used for the annuity’s issuing company influences the amount of interest credit to the contract’s account.
  • Participation Rates – this term describes how much of the gain in the linked index will be credited to the annuity account. For example, if an indexed annuity has a 70% participation rate, the annuity account will be credited with 70% of the gain the index experiences.
  • Spread/Asset/Margin Fees – this fee may be used in lieu of or in addition to a participation rate calculation. It is calculated by subtracting the fee from any index gain percentage. An example would be an indexed annuity that has a 4% spread/asset/margin fee, and the index gains 10% in value; the resulting interest credited to the annuity account would be 6%.
  • Interest Caps – it is critical to understand that most indexed annuities will have a cap on interest credited to the account. In other words, index gains may not be directly represented by interest credited, and the interest accrued isn’t unlimited. For example, depending on the language of the annuity contract, the cap is 10%. If the linked index sees gains in excess of that 10%, such as a market uptick that drives the gain to 12% or more, the account holder will only see interest gains up to the pre-set cap.

It is important to point out here that any guarantees the issuing insurance company makes are based on the ability of that company to pay out claims. Language to this effect is typically found in the annuity contract. Choosing an indexed annuity from a large, stable insurance company makes profound financial sense when these guarantees stand between you and a comfortable retirement.

Why Choose an Indexed Annuity?

As we discussed earlier, there are many financial instruments available to those planning for retirement. Among those is the indexed annuity. Why would someone choose this type of account instead of or in addition to other accounts such as IRAs or stocks/bonds investments?

There are several benefits to the indexed annuity. First, it gives the account holder the ability to see financial gains from the equity markets and stock indexes tied to the account, while it still provides a minimum guaranteed interest rate if those markets see significant downturns. This limits losses of principal invested in the account.

People who are best suited for this type of retirement account tend to be:

  • Risk-averse, wanting to minimize financial losses while providing the opportunity for growth in a controlled manner.
  • Prefer to let others make investment decisions for them. Indexed annuities are a “hands off” account that do not require continual tweaking.
  • Desire a more stable, less-risky situation than other annuity accounts, particularly variable annuities, provide.

If any of these criteria describe your unique retirement planning needs, an indexed annuity may be right for you. Speak to a qualified retirement planner for further details on the kinds of accounts that suit your goals and your financial desires.

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