Lesson in Indexed Annuities Part 3

In previous blog posts in our continuing series on indexed annuities, we’ve spoken about what an indexed annuity is, how it works, and some of the advantages of this retirement planning account over other financial strategies. Our last article covered some of the major features of indexed annuities and how interest formulas are used to determine how interest is credited to the account.

Today we’ll go even deeper, discussing a typical contract, some of the terms used in that contract, and more of the details of indexing methods, which have an impact on the amount of money earned by an annuity investment over the long term.

Indexed Annuity Contracts and Features

As someone planning for retirement, there are myriad ways to set money aside for the future. Each financial account, such as IRAs, employer-matched plans, and direct investments in stocks and bonds, has their own strengths and advantages. Think of indexed annuities as another means to prepare for retirement, especially for those investors who are more risk-averse. Once the contract and account are established, indexed annuities require little or no “maintenance”; since they are tied to a stock index and the contract spells out how interest is accrued and credited to the account, there’s not much to do but sit back and watch the account grow in value.

It is important to understand the terms of a typical indexed annuity contract. The features of this contract help determine how the annuity performs and how much interest is credited to the account as it matures.

First, let’s talk about the index itself. Each indexed annuity is linked to a particular stock market index. These stock market indexes track the performance of a group or family of stocks, usually representing a particular market segment, but sometimes encompassing the entire stock market. For most indexed annuities, the Standard & Poor 500 is the index these annuities are linked to. There are many other indexes, including:

  • Russell 2000
  • Dow Jones Industrial Average
  • NASDAQ 100
  • FTSE 100
  • Nikkei 225
  • NASDAQ Composite
  • Wilshire 5000

It is critical to understand that when you establish an indexed annuity account, you’re not purchasing shares of a stock or its index; rather, these annuities are an insurance contract backed by an insurance company.

The Indexing Method

Next, various indexing methods are used to determine how interest is credited to the account once it is established. As we talked about in the previous article, each insurance company has their own formulas and methods, and the details of these formulas are typically found in the contract language itself. As a refresher, here are three of the major components of a common insurance company formula:

  • Participation Rates – this term describes how much of the value gain in the index linked to the annuity will be credited to the annuity account. As an example, if an indexed annuity has a 75% participation rate, the annuity account will be credited with 75% of the gain the index sees as part of trading activity.
  • Spread/Asset/Margin Fees – Many insurance companies add on fees to the annuity contract. This fee may be used instead of or as an addition to a participation rate calculation. It is calculated by subtracting the fee from any percentage of gain in the index. An example of how this fee works would be an indexed annuity that has a 6% spread/asset/margin fee, and the index gains 12% in value; the resulting interest credited to the annuity account would be 6%.
  • Interest Caps – Most indexed annuities have a cap or maximum limit 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. A good example of a typical indexed annuity contract is thus: imagine the cap is 10%. If the linked index sees gains in excess of that 10%, such as a favorable trading trend that drives the gain to 15% or more, the account holder will only see interest gains up to the pre-set cap.

Glossary of Additional Contract Terms

Indexed annuities often have lengthy contracts filled with legal language and unfamiliar terms for the average person interested in setting aside assets for retirement. It can be helpful to go over some of the common terms one might encounter in a contract document. These terms include:

  • Cap Rate – this is the formal term used for the interest cap discussed above. It represents the limit to the amount of interest credited to the account, regardless of the performance of the linked stock market index.
  • Index Term – this is the period of time over which the interest is calculated in relation to the linked stock market index. It may also mean the period of time in which any withdrawals from the account or surrender charges are subject to penalties or fees.
  • Averaging – rather than use the actual value of an index on a specific date, a number of insurance companies use an average of the performance changes in the index’s overall value to calculate the amount of interest credited to the account. This may have certain advantages, helping to shield the account holder from the ups and downs of a typical stock market index.
  • Interest Compounding – the way an indexed annuity pays interest during the index term can vary. Some accounts pay simple interest, while others compound that interest. In an interest-compounding contract, interest already credited to the annuity account also earns future interest. This has definite advantages in helping the account grow in value over the index term.
  • Floor – this term is another way of expressing the minimum guaranteed interest rate of most indexed annuity contracts. Of course, it is important to point out that this guarantee is dependent on the ability of the issuing insurance company to pay claims.
  • Vesting – depending on the terms contained in the contract, some indexed annuities may not credit any, or may credit only a portion, of the index-linked interest if the annuity is surrendered before the end of the pre-set index term.

There are many more terms in a typical indexed annuity contract, but the list above will help you to gain an understanding of the major features. Specific questions about the contract terms and how the indexed annuity credits interest to the account should be addressed by a qualified retirement planning specialist or insurance provider.

In our installment of this series, we’ll go into further detail about the indexing methods and their advantages and disadvantages for the account holder. Stay tuned for more lessons on indexed annuities!


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