You can think of an indexed annuity as a cake, with a solid layer of security topped by a sweet icing of market exposure.
Indexed annuities, sometimes called fixed indexed annuities or equity-indexed annuities, aren’t direct investments in the market; they are insurance contracts that guarantee a minimum return on your principal for a certain period of time, plus an additional return tied to the performance of a specified market index. When the market does well, you receive an extra chunk of change. When it doesn’t do so well, your balance of capital and earnings-to-date (which is not invested, remember) is not at risk.
Though they may not perform better than direct investments in the market, indexed annuities can top the returns from other low-risk savings vehicles such as CDs, bonds, and money market accounts. And, unlike those products, indexed annuities grow tax-deferred, allowing you to build more wealth faster.1 They can’t beat the tax benefits of funding an IRA or an employer-sponsored retirement plan, but they can offer a desirable alternative for those who have maxed out their retirement accounts, as the IRS imposes no income limit and no limit on annual contributions for a non-qualified annuity (funded with after-tax dollars).2
Indexed annuities can also provide a lifetime guaranteed income stream if you purchase an add-on income rider, which may be called a guaranteed lifetime withdrawal benefit (GLWB) or a Guaranteed Minimum Income Benefit (GMIB). The terms for income riders vary by provider, but basically they guarantee regular payments during your lifetime, and maybe also to a spouse or other beneficiary after you are gone, and might even continue paying through that person’s lifetime. This payment amount is calculated based on several factors including how long you wait to start receiving payments, your age, and your life expectancy. Generally, you must pay an annual fee for an income rider.3,4
In exchange for the security they provide, indexed annuities only pay out partial gains when the market rises. They usually include a cap on the amount you can earn each period, and they often limit earnings to a portion of the market’s gains as well, by imposing a participation rate or a margin.5
A participation rate is a percentage of market gain that will be passed along to you. For example, if the participation rate is 75% and the market rises by 8% one year, your account balance of $50,000 will earn 6% (which is 75% of 8%) or $3,000 for that period, minus any fees. However, the contract may cap your earnings at 5%, in which case you will not get the full 75% of the gain.
In the above scenario of an 8% market rise, your annuity would earn 3% less than if you had invested the same funds directly in the market during that year. However, during years when the market did not perform as well, you would be earning the minimum guaranteed rate, which could be more than you would get by directly investing in the market.
For contracts that specify a margin instead of a participation rate, the margin percentage is subtracted from the market gain to get your earnings rate. A market rise of 8% and a 2.5% margin would therefore lead to a 5.5% earnings (8% - 2.5%) on your $50,000, or $2,750 (minus any fees) credited to your account for that period. Again, a contract may cap your total annual gain.
Different providers of indexed annuities calculate the various rates in different ways. Your account may be credited with a gain annually. Some providers may even use each year’s new balance as the basis to calculate the next year’s earnings, allowing you to benefit from compounding interest. Others may simply do a one-time calculation of earnings over the entire period of the annuity when the contract ends. Some contracts may allow a provider to modify the participation rate at any time, which could lead to lower than expected earnings.6
An indexed annuity can be viewed as a relatively illiquid, long-term investment strategy. Usually the contract will specify a period of up to 10 years during which money withdrawn from the annuity is subject to a penalty or surrender charge. This can be offset by an annual withdrawal amount, which may allow you to withdraw a certain percentage of the balance each year without penalty.
Planning for Inflation: Cost-of-Living Adjustment, or COLA, riders can be contractually added to some annuity policies at the time of application. You can choose the percentage you want the income to increase by on an annual basis, and for the life of the policy. An Inflation Protected Annuity (IPA) is similar to a regular immediate annuity, but its payments are indexed to the rate of inflation. However, oftentimes there is a cap, and investors do not receive payments beyond this percentage. One efficient way to address future price increases is to have contractual income streams starting at different times. Just like you can ladder CDs or bonds with different maturities, you can also ladder lifetime income.4
If you are planning to maintain or improve your quality of life in retirement, maybe you would like to see how fixed indexed annuities can potentially help you. If that’s the case, then ask a qualified insurance or financial advisor about them today.