Lesson in Indexed Annuities Part 4

Part 1

Part 2

Part 3

Our last blog post in the series on indexed annuities covered many common terms that are found in the annuity contracts. We’ve touched on the indexing methods insurance companies use to determine how interest is credited to the annuity account, and in today’s article we will go much deeper. Various indexing methods are used by insurance companies, and we will cover some of the most common methods along with providing information on the strengths and weaknesses of each one we cover.

We will also introduce the concept of “indexed annuity riders”. These riders are simply contracted language that provides additional guarantees and flexibility to the annuity contract. Again, each insurance company is different in how they set up their annuity contracts, and not all will offer these riders. Understanding them, however, is an important part of the overall process, especially if the contract you are investigating has riders of this type.

Indexing Methods by Type

We’ll discuss three of the most common indexing methods as well as information on the advantages and disadvantages of each method so that people planning for retirement can make informed choices. These three methods are:

  • Annual Reset
  • High Water Mark
  • Point-to-Point

The Annual Reset Method

The Annual Reset, sometimes referred to as the Ratchet method, is a way insurance companies determine the index-linked interest credited to the account. By comparing the index value at the end of the contract year with the value the index had at the beginning of the same contract year, a percentage is calculated. Interest calculated in this way is added to the annuity account each year during the contract term. Declines are ignored.

Advantages include:

  • Any future decreases the index experiences will not affect interest already earned by the annuity.
  • More interest may be credited than other indexing methods, especially when the index itself experiences gains and losses during the contract term.
  • Gains determined by this indexing method are locked in for each year of the contract term.

Some of the disadvantages of the annual reset calculation method include:

  • Participation rates may change, even on an annual basis, and in general are lower than in other indexing methods used by insurance companies.
  • This method may be used or combined with other common contract features, such as interest caps and averaging strategies in an effort to limit the amount of interest credited to the account each year of the term.

The High Water Mark

In this interest-calculating method, the insurance company looks at the linked index’s value at several points during the contract term (typically at the anniversary of the account establishment). The interest credited to the account is then based on the difference between the highest value the index experienced and the value of the index at the start of the term. The interest is then credited at the end of the contract term.

Some of the advantages of this indexing method include:

  • Higher interest may be credited to the account than in other indexing methods, particularly if the index experiences a peak toward the beginning or in the middle of the contract term and begins a downward slope or loss at the end of the term.
  • Providing a cushion or shield against declines in the value of the linked index.

Disadvantages include:

  • The common practice of including this indexing method with other features that limit the credited interest to each account. Features like lower participation rates and lower interest caps may affect the overall value of the account and the interest credited to it.
  • Because interest is not credited to the account until the end of the contract term, any interest accrued during the term may not be paid if the account is surrendered before the end of the specified term.

The Point-to-Point Method

Just like the name implies, this indexing method approaches the interest-crediting calculation by looking at two distinct points of the contract term and comparing the change in value of the index at those points. Usually, insurance companies will use the creation date of the contract and the ending date of the same contract as the two points.

The primary advantage of this method is that it may be combined with other common features, specifically a higher cap rate or a high participation rate, which may help the account holder to earn a higher rate of return on his or her investment due to the higher level of interest credited.

Disadvantages of the point-to-point method include:

  • It relies on a single point in time during a contract term, rather than a value averaging strategy, to calculate credited interest. This can result in a loss of an earlier gain if the index value declines toward the end or at the end of the term.
  • Just like in the high water mark method, interest is not credited to the account until the end of the term. This may impact payment of interest if the account is surrendered before the term is completed.

Indexed Annuity Riders

At the beginning of this article, we introduced the idea of indexed annuity riders. These are additions to the contract which are designed to provide the account holder with more flexibility and further guarantees. The three most popular and common riders include:

  • Enhanced Death Benefit – if you wish to pass on a financial legacy to a family member or heir, an enhanced death benefit is a great idea. There are many types of such a rider. Some riders of this type will guarantee that the death benefit will increase a specific amount each year of the annuity contract term, while others may offer a stream of income to go along with the death benefit.
  • Guaranteed Lifetime Withdrawal Benefit (GLWB Rider) – this rider provides a guaranteed withdrawal of assets over the lifetime of the account holder, without forcing the account holder to annuitize the contract. These withdrawals are allowed to continue, even if the account’s value is depleted. The account holder may stop taking withdrawals but still retain access to any principal invested that remains in the contract. Just like in other retirement accounts, withdrawals are subject to income taxes, and there may also be significant tax penalties for withdrawals made before the age of 59 ½ years.
  • Long-Term Care Rider (LTC Rider) – for expenses associated with long-term medical or life care, an LTC rider offers the account holder increased flexibility. This type of rider gives the account holder access to part of the principal invested in the annuity to help pay for care, even without financial penalties like surrender charges. An added bonus is that money withdrawn to pay for care is not counted as income, helping save costs associated with income tax.

Not all riders are included in all indexed annuities. In fact, these riders are options, and may require additional fees to establish. As always, consult with your insurance company and certified retirement planners to learn more about which features of an indexed annuity are right for your financial goals and future needs.

Next Up

In our next installment, we’ll cover even more options available to those planning for retirement when they are ready to explore indexed annuities. Stay tuned!=


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