Indexed Annuities

Shawn Plummer

CEO, The Annuity Expert

What is an Indexed Annuity?

An indexed annuity, often referred to as a fixed index annuity or equity index annuity, is a type of annuity that earns interest based on the performance of a specific market index, such as the S&P 500, Nasdaq, or Dow Jones. Unlike direct investments in these indices, indexed annuities offer principal protection, ensuring that your initial investment remains safe regardless of market downturns.

A new type of index annuity called a registered-linked index annuity is not the same as an equity or fixed-indexed annuity. A RILA is a hybrid of an indexed and variable annuity. It is exposed to some risk of losing money, unlike a fixed or equity-indexed annuity, which is not exposed to market risk.

How Does an Index Annuity Work?

The interest earned on an indexed annuity is linked to the performance of the chosen index. However, it’s essential to understand that you’re not directly investing in the stock market. Instead, your earnings are based on the index’s performance, subject to certain factors like the participation rate, cap, and specified floor.

  • Participation Rate: This determines how much of the index’s gain will be credited to the annuity. For instance, a 70% participation rate means you’ll receive 70% of the index’s growth.
  • Cap: Some annuities set a maximum limit on the interest you can earn, known as the cap. If the index gains 10% and your cap is 7%, you’ll only earn 7%.
  • Specified Floor: This is the minimum interest rate you’ll earn, even if the index performs poorly.

How Does an Indexed Annuity Differ from a Fixed Annuity?

While both are insurance products designed to provide income, the primary difference lies in how they earn interest. A traditional fixed annuity provides a guaranteed interest rate, while an indexed annuity’s interest is tied to the performance of a market index. This means FIAs offer the potential for higher returns, but with that comes a bit more complexity.

Feature/AspectIndexed AnnuitiesFixed Annuities
Interest EarningBased on a specific market index’s performance.Earns a predetermined, guaranteed interest rate.
Principal ProtectionYes, the initial investment is protected.Yes, the initial investment is protected.
Potential for Higher ReturnsYes, if the market performs well.No, returns are fixed and typically lower than indexed annuities in a strong market.
Predictability of ReturnsCan be unpredictable due to market fluctuations.Highly predictable due to the fixed interest rate.
Caps on ReturnsOften has caps limiting the maximum interest earned.No caps, but the interest rate is fixed and predetermined.
Participation RateYes, determines the percentage of index’s gain credited to the annuity.Not applicable.
Specified FloorOften present, ensuring a minimum interest rate.Not typically needed due to the fixed interest rate.
Flexibility in EarningsEarnings can vary based on index performance.Earnings are consistent and unchanging.
Penalty-Free WithdrawalsOften allowed up to a certain percentage.May or may not be allowed, depending on the contract.
Inflation ProtectionSome offer increasing income options.Typically does not offer inflation protection.
Contribution LimitsTypically no limits.Typically no limits.

Who Would Benefit From Indexed Annuities?

  • Moderate Investors: Those who want some growth potential without the full risk of the stock market.
  • Near-Retirees: People close to retirement who want a mix of safety and growth.
  • Long-term Savers: Those who plan to invest for many years and benefit from potential market-linked growth.
  • Safety Seekers: Individuals who don’t want to lose their initial investment, regardless of market ups and downs.
  • Inflation-Conscious: Those who want their income to potentially increase over time to keep up with rising costs.
  • Tax Planners: Investors who want to delay paying taxes on their earnings until they withdraw them.
  • Extra Retirement Savers: People who’ve maxed out other retirement accounts and want another way to save.
  • Emergency Planners: Those who want the option to withdraw some money without penalties if needed.
  • Estate Planners: Individuals who want to ensure their loved ones receive a guaranteed amount when they pass away.

Index Annuity Pros and Cons

Pros:

  • Principal Protection: Your initial investment is safe, regardless of market performance.
  • No Contribution Limits: Unlike other retirement accounts, there’s no cap on how much you can invest.
  • Penalty-Free Withdrawals: Many indexed annuities allow you to withdraw a portion of your money without penalties.
  • Guaranteed Lifetime Withdrawal Benefit: This feature ensures a steady income stream for life.

Cons:

  • Caps on Returns: Your earnings might be limited if the index performs exceptionally well.
  • Potential for Lower Returns: If the index doesn’t perform, your returns might be lower than other investment options.

Index Annuity Rates

These rates are influenced by the participation rate, cap, and whether the annuity is uncapped. An uncapped annuity doesn’t limit the potential interest, but it might have a lower participation rate.

Different Indexing Methods

Equity-indexed annuities utilize various indexing methods to calculate the gain in the linked index. These methods include annual reset, high-water mark, and point-to-point.

1. Annual Reset: This indexing method calculates the interest based on the index’s performance over a one-year period. At the end of each year, the annuity resets, and any gains are locked in. This method provides a fresh start each year, allowing the annuity to capture market gains.

2. High-Water Mark: With this indexing method, the annuity records the highest index value over a specific time frame, usually annually. The gains are based on the difference between the highest high-water mark and the initial index value. This approach offers the potential for higher returns when the market reaches new highs.

3. Point-to-Point: The point-to-point indexing method compares the index value at the start and end points of a specific term, commonly annually. The interest is based on the percentage change in the index value during that time frame. This method allows annuity holders to benefit from the overall market performance.

Indexed Annuity

Annual Reset

This feature allows your gains to be locked in annually, ensuring that future losses in the index won’t affect the interest you’ve already earned.

Scenario: Lisa’s indexed annuity is worth $150,000. The linked index, the S&P 500, grows by 7%, increasing her annuity value to $160,500. The next year, the S&P 500 drops by 6%.

Outcome: Thanks to the annual reset feature, Lisa’s annuity value stays the same from the previous year ($160,500).

Inflation and Increasing Income

One concern with annuities is the eroding power of inflation. Some indexed annuities offer increasing income options to counteract this, ensuring your income keeps pace with rising costs.

Index Annuity

What is the Best Index Annuity?

The “best” indexed annuity varies based on individual needs. Consider factors like the participation rate, cap, and any additional features like guaranteed lifetime withdrawal benefits. Always consult with an anuity broker to determine the best fit for your situation as products and rates change regularly.

The general rule of thumb is to stick with annuity companies that hold an “A- or better” rating with S&P and A.M. Best.

How Does An Indexed Annuity Differ From A Fixed Annuity?

Next Steps

Indexed annuities offer a unique blend of potential market-linked growth with the safety of principal protection. While they might not be suitable for everyone, understanding how they work, their benefits, and potential drawbacks can help you make an informed decision. Remember, the goal is to secure a financial future that aligns with your needs and aspirations. Contact us for a quote below.

What Is An Indexed Annuity?

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Frequently Asked Questions

How does an indexed annuity work?

An indexed annuity is a contract between you and an insurance company where you can expect returns based on the performance of a market index. The contract has two stages: the accumulation (savings) phase and the annuity (payout) phase.

What are the pros and cons of indexed annuities?

The product being offered has certain advantages and disadvantages. On the positive side are tax-deferred growth and principal protection from a possible stock market crash. On the negative side, there is limited potential for increased value, and the index strategies involved can be complex. Additionally, all interest earned is locked in, preventing loss of money, and involves surrender charges. The interest earned is based on how the stock market performs.

Do you pay taxes on index annuity?

According to current federal income tax law, the interest you earn on your indexed annuity is not subject to taxes immediately. You will only need to pay ordinary income taxes on any taxable amount once you start receiving payments from the contract.

Can you withdraw from an indexed annuity?

You can withdraw funds from an annuity before it’s turned into periodic payments, but you may have to pay a surrender charge if you withdraw before the agreed term. However, you usually won’t be charged a penalty for withdrawing after the term ends.

How do index annuities make money?

Indexed annuities allow your money to earn interest based on positive changes to an external index like the S&P 500 over a predetermined time frame. If the index increases, you’ll receive a percentage of the gains. If the index decreases, it won’t affect your contract value, including any interest you previously earned.

Shawn Plummer

CEO, The Annuity Expert

Shawn Plummer is a licensed financial professional, insurance agent, and annuity broker with over 14 years of first-hand experience with annuities and insurance. Since beginning his journey in 2009, he has been pivotal in selling and educating about annuities and insurance products. Still, he has also played an instrumental role in training financial advisors for a prestigious Fortune Global 500 insurance company, Allianz. His insights and expertise have made him a sought-after voice in the industry, leading to features in renowned publications such as Time Magazine, Bloomberg, Entrepreneur, Yahoo! Finance, MSN, SmartAsset, The Simple Dollar, U.S. News and World Report, Women’s Health Magazine, and many more. Shawn’s driving ambition? To simplify retirement planning, he ensures his clients understand their choices and secure the best insurance coverage at unbeatable rates.

The Annuity Expert is an independent online insurance agency servicing consumers across the United States. The goal is to help you take the guesswork out of retirement planning and find the best insurance coverage at the cheapest rates

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