What Is an Indexed Annuity? Pros and Cons Explained

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Written By: Bara Goldberg

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Bara Goldberg

Bara Goldberg - Amanda Dobanton Esq. is a General Counsel for Fairfield Funding. She has been crucial to the growth of Fairfield Funding for the past 9 years. Prior to Fairfield, she interned at a law firm in Gwinnett County. Ms. Dobanton received a B.S. in History and Political Science from Brenau University and went on to obtain her Juris Doctorate Degree from Atlanta’s John Marshall Law School. Amanda is currently serving on the Board for the National Association of Settlement Purchasers. Amanda is a seasoned expert in the structured settlement and annuity field.

A lump sum or one time payment

Indexed annuities combine features of both fixed annuity and variable annuity. Like fixed annuities, they provide principal protection and the opportunity for guaranteed lifetime income. However, rather than paying a fixed interest rate, the returns of an indexed annuity are based on the performance of a specified market index, such as the SP 500 index.

How Do Indexed Annuities Work?

When you purchase an indexed annuity, also called a fixed indexed annuity or an equity indexed annuity, your funds are not directly invested in the market index. Instead, the insurance company uses a crediting method to calculate your returns based on a portion of the index’s gains. The three most common crediting methods are:

Point-to-point: Compares the index value at the beginning and end of the crediting period (e.g. 1 year)

Monthly sum: Tracks index performance each month and sums up the monthly returns

Monthly average: Takes an average of the index value each month

By linking returns to a market index, fixed index annuities offer the potential for higher yields than fixed annuities in strong markets. At the same time, your principal is protected from market losses. If the index declines, you won’t lose money, but you may receive little or no interest for that period.

Types of Indexed Annuities

There are two main types of indexed annuities:

Equity-Indexed Annuities (EIAs):

EIAs are the most common type of indexed annuity. They credit interest based on the performance of an equity index, subject to a guaranteed minimum rate. For example, an EIA might guarantee a minimum 1% return, even if the market index declines, while offering the potential for higher returns up to a set cap if the index performs well.

Registered Index-Linked Annuities (RILAs):

RILAs are a newer type of indexed annuity that provide a level of protection against market losses but do not guarantee a minimum interest rate. Instead, they use a buffer or floor to limit losses. For instance, a RILA with a 10% buffer would protect you from the first 10% of index losses. In exchange for this downside protection, RILAs typically cap your potential gains.

Factors Affecting Indexed Annuity Returns

While indexed annuities offer the potential to benefit from market gains, several factors can impact your actual returns:

Participation Rates: The participation rate determines the percentage of the index’s gain that will be credited to your deferred annuity. For example, if the participation rate is 80% and the index gains 10% during the index term, your annuity would be credited 8%. Some equity indexed annuities have participation rates of 100% or more, while others may be as low as 25%.

Spreads, Margins, and Fees: Some indexed annuities apply a spread, margin or asset fee, which is subtracted from the interest rate. For example, if the index gained 10% and the annuity had a 3% spread, the interest credited would be 7%. These fees can impact your annuity rate and long-term returns.

Interest Rate Caps: Most indexed annuities set a maximum rate of interest that can be credited in a given contract term. So if your annuity has an 8% cap and the index gains 12%, your return would be limited to 8%. Caps can limit your upside potential, especially in strong market years.

It’s important for annuity holders to understand that participation rates, spreads and caps can change over time. Many indexed annuities offer more attractive rates in the early years to entice investors. Carefully review the personal information in your contract to see how and when the financial services company can make adjustments.

Pros of Indexed Annuities

Indexed annuities offer several potential benefits that can make them an attractive option for retirement savers:

1. Protection Against Market Downturns

One of the primary advantages of this annuity product is the protection it offers against market loss. Even if the stock market experiences a significant decline, your principal investment remains secure. This characteristic makes indexed annuities an attractive option for risk-averse investors who want to preserve their capital and avoid potential losses.

2. Potential for Higher Returns

Compared to traditional fixed annuities, indexed annuities offer the potential for higher returns. By receiving index-linked interest through an annual reset or other crediting method, you can benefit from the growth of the stock market without directly investing in individual stocks. This feature appeals to investors who seek the opportunity for better returns than those provided by fixed annuities.

3. Guaranteed Income Stream

Indexed annuities can provide a guaranteed income stream during retirement, similar to Social Security or a pension. Many annuity contracts offer an optional income rider that allows you to convert the accumulated value into a series of payments that last for a specified period or even for the remainder of your life. This predictable income stream can help alleviate concerns about outliving your savings in retirement.

4. Tax-Deferred Growth

Another advantage of an index annuity is the tax-deferred growth it offers, as outlined in the tax library. Any earnings within the annuity grow on a tax-deferred basis, meaning you won’t owe taxes on the gains until you withdraw the money. This feature allows your money to compound faster compared to taxable investments.

5. Beneficiary Protection and Probate Avoidance

Indexed annuities allow you to designate beneficiaries who will receive the remaining annuity value upon your passing, similar to life insurance. This bypasses the lengthy and costly probate process and provides quick and efficient access to funds for your loved ones during a difficult time.

6. Psychological Benefits of Reduced Risk with Some Upside Potential

Indexed annuities offer peace of mind by protecting your principal against market downturns while still providing the potential for higher returns. This combination of safety and growth potential can be emotionally appealing and reduce financial stress in retirement planning.

7. Inflation Protection Historically

While not guaranteed, fixed index annuity has historically provided a measure of inflation protection. By participating in a portion of market gains, it has the potential to outpace inflation over the long term, helping to preserve the real value of your retirement savings.

Cons of Indexed Annuities

While indexed annuities have attractive features, there are also potential drawbacks and risks to consider:

1. Complexity and Lack of Transparency

One of the main drawbacks of indexed annuities is their complexity. The formulas used to calculate returns can be difficult to understand, and the various caps, participation rates, and fees associated with these products can make it challenging to compare different annuity options. This lack of transparency can lead to confusion and potential misunderstandings for annuity customers.

2. Limited Upside Potential

While indexed annuities offer the potential for higher returns compared to fixed annuities, they also come with limitations. The presence of caps and participation rates can restrict the amount of growth you can achieve, even if the underlying index performs exceptionally well. This limited upside potential may not be suitable for investors seeking to maximize their returns.

3. Surrender Charges and Penalties

Indexed annuities often come with surrender periods, during which you may face penalties for withdrawing money from the annuity. These surrender charges can be substantial, especially in the contract’s early years. Therefore, understanding the surrender period and associated charges is crucial before purchasing an indexed annuity.

4. Opportunity Cost

By investing in an indexed annuity, you may miss out on other investment opportunities that could potentially offer higher returns. While indexed annuities provide a level of protection and the potential for growth, they may not be the most suitable option for investors with a higher risk tolerance or those seeking more aggressive growth strategies.

5. Dependence on Index Performance on Specific Dates

Indexed annuities calculate returns based on the linked index’s performance on specific dates, typically annually. If the index drops significantly near the reset date, your returns for that period could be negatively impacted, regardless of the index’s performance throughout the rest of the year.

6. High Commissions Incentivizing Sales

Insurance agents and financial professionals often receive high commissions for selling indexed annuities, which can create conflicts of interest. These commissions may incentivize salespeople to promote indexed annuities even when they may not be the best fit for a client’s needs.

7. Inconsistent Regulation as Insurance vs. Investment Products

Indexed annuities are regulated as insurance products rather than investment products, leading to inconsistencies in oversight and consumer protection. This inconsistent regulation can make it difficult for consumers to understand their rights and the potential risks associated with indexed annuities.

Regulation of Indexed Annuities

Indexed annuities are primarily regulated at the state level by insurance commissioners. Insurance companies must file their indexed annuity products with each state in which they are sold and comply with state regulations on insurance advertising, disclosures and suitability.

Some indexed annuities are also regulated by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). These are typically indexed annuities that are registered as securities, due to certain features such as risk of loss to principal. Registered indexed annuities must provide a prospectus that details the terms, costs and risks of the product.

Whether an indexed annuity is state or federally regulated, it’s important to review all sales materials and disclosures carefully before making a purchase decision. Don’t hesitate to ask questions, and make sure you fully understand how the annuity works.

Indexes Linked to Annuities

When it comes to indexed annuities, the performance of your investment is tied to a specific market index. The index selection can have a significant impact on the potential returns and risks associated with your annuity. Let’s explore some of the commonly linked market indexes and the implications of choosing one over another.

Common Market Indexes

Is an Indexed Annuity Right for You?

Determining whether an indexed annuity is a good fit for your financial situation requires careful consideration of your goals, risk tolerance, and investment timeline. Here are some factors to keep in mind:

1. Risk Tolerance

If you are a conservative investor who prioritizes principal protection and is willing to accept limited upside potential in exchange for downside protection, an indexed annuity may be a suitable option.

2. Retirement Income Needs

If you’re looking for a guaranteed income stream in retirement and want to supplement your other income sources, an indexed annuity can provide a predictable flow of payments.

3. Investment Timeline

Indexed annuities are generally more suitable for long-term investors who can withstand the surrender periods and are comfortable with the limited liquidity during the early years of the contract.

4. Diversification

Indexed annuities can serve as a component of a well-diversified retirement portfolio, helping to balance risk and provide a level of stability. However, it’s essential to consider other investment options and not rely solely on indexed annuities for your financial needs.

Seek Professional Advice

Given the complexity of indexed annuities and the various factors to consider, it’s highly recommended to consult with a qualified financial advisor before making a decision. A financial advisor can help you assess your financial situation, evaluate the pros and cons of indexed annuities in relation to your goals, and determine whether this type of annuity is a good fit for your overall financial plan.

When seeking advice, look for a professional financial advisor who is legally obligated to act in your best interests. Be cautious of annuity sales representatives who may have financial incentives to promote specific products, and always take the time to thoroughly understand the terms and conditions of any annuity contract before making a commitment.

Conclusion

An indexed annuity can offer a unique combination of principal protection, the potential for higher returns, and a guaranteed income stream in retirement. However, they also come with complexities, limitations, and potential drawbacks that should be carefully considered.

Remember to seek guidance from a trusted financial advisor and thoroughly review the terms of any annuity contract before making a purchase.

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Bara Goldberg Finance Writer

Bara Goldberg - Amanda Dobanton Esq. is a General Counsel for Fairfield Funding. She has been crucial to the growth of Fairfield Funding for the past 9 years. Prior to Fairfield, she interned at a law firm in Gwinnett County. Ms. Dobanton received a B.S. in History and Political Science from Brenau University and went on to obtain her Juris Doctorate Degree from Atlanta’s John Marshall Law School. Amanda is currently serving on the Board for the National Association of Settlement Purchasers. Amanda is a seasoned expert in the structured settlement and annuity field.