What Is An Indexed Annuity Pros And Cons

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 7 minute read

You may choose between a fixed-rate mortgage and an adjustable-rate mortgage when you’re ready to finance your new house. But what if there was a third choice that offered better rates than a fixed loan but less risk than an adjustable one?

Many annuity investors have been in a bind over the past several years due to the turbulence of the markets: they may either accept the relatively low rates given by fixed contracts or they can risk their money in a variable annuity, which is tied to the ups and downs of the debt and stock markets.

But unlike the world of mortgages, the annuity market now offers borrowers a third option. To bridge the gap between the safety and security of fixed-rate products and the inherent risk of variable-rate contracts, equity-indexed annuities were developed. First, it’s helpful to understand what indexed annuities are and why they’re useful.

The Fundamentals of Equity-Indexed Annuities

There is a unique subset of fixed annuities known as equity-indexed annuities. The money in an indexed annuity is protected from loss and you get exposure to a stock market index like the S&P 500.

You may benefit from the potential expansion of the stock market while keeping at least one foot firmly planted on solid ground. If used properly, these vehicles can generate higher rates of return while letting cautious investors get a good night’s rest.

In many ways, equity-indexed annuity contracts are similar to their fixed-rate equivalents. They can grow tax-free and have a predetermined maturity of anything from one to ten or fifteen years. They also offer the same protections against creditors and probate.

On the other hand, most equity-indexed contracts do not offer a guaranteed rate of interest like traditional fixed annuities. Instead, you’ll get a piece of the gains made by the stock market index that the contract tracks. There are a number of variables that affect the participation rate, but it is normally between 60% and 90%.

For example, if you purchase an S&P 500 contract and this index rises by 20% over the seven-year term of the contract, you would realize perhaps three-quarters of that growth – without risking the principal.

Indexed Annuities: A Brief History

The indexed annuity is the most modern investment option for retirees. The KeyIndex product was originally offered by Keyport Life Insurance in 1998. (a few contracts of which I sold that year through Quick & Reilly). More than 40 companies that provide life insurance now sell indexed annuities.

Since their establishment, these vehicles have had yearly inflows of billions of dollars, and they have seen corresponding increases in their participation rates and ceilings. Additionally, insurance providers are consistently developing innovative forms of indexed annuities that let investors take part in the market safely while facing a wide range of constraints.

The Securities and Exchange Commission (SEC) attempted to regulate indexed annuities as market securities in 2009, but this was met with fierce opposition from the life insurance industry and ultimately was ruled unconstitutional.

At Work with Equity-Indexed Annuities

Although most indexed products appear straightforward to the average investor, their inner workings can be rather sophisticated. This is how contracts usually go down: The annuity provider takes the investor’s premium and splits it in half:

  1. The majority of the funds are invested internally in a safe portfolio of assets that is guaranteed to return the full amount of premium paid by the contract’s expiration date.
  2. The remainder is allocated to the purchase of call options on the underlying stock index. These call options are a sort of derivative whose value will increase exponentially more than the underlying index’s growth when the underlying index rises. This profit is subsequently utilized to share the increase with investors.

In addition to the participation percentage, almost all indexed contracts also have an annual cap, often set at 10%. (Because of these limits, savvy investors may use this approach on their own and earn considerably bigger profits than they would from bundled contracts.)

Indexed Annuity Illustration

Hans places $100,000 in a seven-year indexed annuity contract with a participation rate of 70% and a ceiling of 12%. In the first year, the index is based on the S&P 500 and grows by a stunning 30%. Because the entire benefit from the participation rate surpasses this amount (70% of 30% = 21%), Hans total gain is restricted at 12%.

Some contracts maintain the profits from the previous year and reset the caps each year, whilst others compute gains on a cumulative basis during the contract’s life. As a sort of consolation, state law stipulates that indexed contracts compensate investors with at least a small amount of guaranteed interest if the underlying benchmark index does not grow throughout the period.

Indexed Annuities: How Are They Taxed?

A contract for an equity-indexed annuity is taxed like any other annuity. Taxes are not paid on the earnings of these accounts until the money is withdrawn. Taking a payout before age 59 1/2 incurs an extra 10% early withdrawal penalty from the IRS, and all distributions are reported and taxed as ordinary income.

Each periodic payment includes a portion of the premium put into the contract, calculated on a pro rata basis based on the exclusion ratio, and is not subject to taxation (the ratio of principal contributed versus current contract value). If you invest $50,000 initially and your contract increases to $75,000 over time, then two-thirds of each dividend will be treated as a return of principle.

Methods of Payment

All other types of annuity payouts are available with indexed annuities as well, including:

  • Joint Life. payments continue until both beneficiaries are deceased, unlike with straight life. The actuarial value of a joint life payment plan depends on the length of the lives of both participants.
  • True to Form Every so often, in a predetermined amount of money, till your death. The largest recurring payment is offered by this method, but if you die before collecting back the entire value of the contract, the insurance company keeps the difference.
  • Period-Guaranteed Survival in Life. A predetermined cash amount will be paid to you on a recurring basis until the earlier of your death or the end of a certain time period, say 20 years. Period specific settings safeguard contract valuables so that insurance companies cannot claim them in the event of a beneficiary’s untimely death.
  • A Marriage for Life, with an Uncertain Beginning and Ending. Payments to you and your co-beneficiary will continue on a regular schedule until either you or they reach a certain age or the end of a specified length of time (for example, 20 years).
    To do this, you can either accept the cash value of the contract in one lump sum or roll it over into a new annuity plan.
  • Departure in a Methodical Manner. Payments will be made on a regular basis and will be either a set monetary amount or a percentage of the total contract value. Qualified contracts frequently utilize this strategy for IRA required minimum distributions.

Should You Consider Investing in an Indexed Annuity?

If you’re looking to earn more than you would with more conventional guaranteed contracts but can’t afford to lose your initial investment, you might want to investigate indexed annuities.

You should be prepared, however, to give up any actual gains if the underlying benchmark index on which the contract is based underperforms throughout the life of the contract. The target demographic for these vehicles are retirees who want to maintain some equity exposure.

Indexed Annuities in Your Portfolio: How to Use Them Correctly

How one should allocate these holdings within a retirement portfolio is not determined by any hard and fast guidelines. A hypothetical investor with a $500,000 portfolio who only holds certificates of deposit and fixed annuities illustrates this point. Perhaps he or she would profit from hedging their bets against inflation with a longer-term contract that has a greater cap and participation rate.

Beware of Scams and Fraud

While equity-indexed annuities are a good fit for certain cautious investors, some unscrupulous insurance salespeople and financial consultants target financially illiterate retirees in an effort to convince them to liquidate their whole life savings and invest it in the products.

While these contracts may provide some liquidity, they are not suitable as the only investment vehicle for retirement planning. Marketers frequently pose as senior consultants by earning a meaningless financial certificate that can be achieved in a week or two of study. 

The next step is to bring a big group of seniors to a “power lunch,” where they will receive a free meal in exchange for listening to a persuasive speech on the boundless benefits of indexed goods.

There’s usually a lot of pressure on the audience to make an instantaneous investment in these things without giving it any thought. Both federal and state officials, as well as the SEC, are keeping a careful eye on this behavior. If someone offers you a free meal and the chance to “secure” your retirement for life, run the other way.

Bottom Line

Although equity-indexed annuities are a great way for cautious investors to get market exposure, they are also vulnerable to abuse. Those who stand to gain from these items would do well to read the fine print carefully and make sure they fully grasp its terms and conditions. Talk to your life insurance agent or financial advisor if you want to learn more about indexed annuities.

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