Indexed Annuities

What is an Indexed Annuity?

Annuities are long-term investments that can help to secure your financial future. All annuities earn interest over time, and indexed annuities earn interest with a guaranteed return based on an external index.

In exchange for a lump sum or periodic payments, an indexed annuity owner — or annuitant — will receive payments at a later date for a set period of time, including any additional income earned from the external index. While they are primarily used to finance retirement funds, annuities can also be used to renovate a home or pay for college tuition.

How Does an Indexed Annuity Work?

Indexed annuities — also known as fixed indexed annuities or equity indexed annuities — are meant to provide a reliable stream of income throughout an annuitant’s life. They can be purchased through an issuing insurance company in exchange for a one-time lump sum or periodic premium payments. In return, an annuity owner is guaranteed to receive a predetermined payout stream.

As with variable annuities, indexed annuity owners can invest in the stock market through an external index. As a result, they can earn a higher rate of return based on positive index performance. What sets indexed annuities apart from variable annuities is the added protection provided against market declines. Investing in a variable annuity comes with the risk of losing any additional interest if stocks and mutual funds perform poorly. With an indexed annuity, if the market declines you are still guaranteed to receive a minimum return.

However, there are constraints to any return on interest. Insurance companies include a participation rate for indexed annuity contracts, which is the amount the contract will grow based on the external index’s percentage increase. For example, if the annuity’s participation rate is 80 percent and the index increases by 10 percent, the rate of return credited to the annuity account would be 8 percent. In most cases, the participation rate is less than 100 percent and is based on the length of the annuity contract. In addition, most indexed annuity contracts include a cap on the gained interest. If there is a 10 percent cap, and the index increases by 55 percent, the maximum return an annuitant will receive is 10 percent.

Similar to many annuities, indexed annuity contracts are difficult to alter. In the event an annuitant needs funds for an unexpected emergency, insurance companies will charge surrender fees if withdrawn before the disbursement period. However, many annuity contracts offer penalty-free annual withdrawals for up to 10 percent of the initial value.

Fixed vs. Fixed-Indexed Annuity

Just as indexed annuities share some characteristics of variable annuities, the same proves true for fixed annuities. A fixed annuity contract guarantees a set rate of return on every disbursement. The amount does not fluctuate and the payout terms are predetermined prior to disbursement.

Similar to fixed annuities, an indexed annuity — or fixed-indexed annuity — also guarantees a minimum rate of return. This is a beneficial trait should the stock market index fluctuate over time or perform poorly. The added protection prevents any unnecessary losses of interest gains, and also provides the opportunity to receive a higher rate of return should the index perform positively.

Pros and Cons of Indexed Annuities

Indexed annuities are a low-risk alternative to variable annuities, and provide a guaranteed stream of income. Similar to other annuity types, this investment option allows for savings to accrue interest on a tax-deferred basis, and contracts can be tailored to an annuitant’s needs. However, it is important to weigh all benefits and risks prior to investing in this financial vehicle.

In addition to providing tax-deferred income, indexed annuities offer a number of benefits including:

  • Guaranteed income
  • Potentially higher rate of return
  • Full protection of principal from volatile stock market index
  • Accrued interest
  • Investment in outside markets

On the other hand, indexed annuities carry a number of drawbacks. Some of the disadvantages of investing in this annuity type include:

  • Low cap rates
  • Participation rates
  • Withdrawal fees
  • Inflexible contract terms
  • Difficult to understand

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