What Is an Indexed Annuity?

An annuity is a contract between you and an insurance company to provide a steady income stream during retirement. You invest funds during the accumulation phase, annuitize the contract when you’re ready to retire, and begin receiving regular income during the payout phase. Riders might be available for an additional fee to create a death benefit for your beneficiary or beneficiaries.

Most annuities come with surrender fees. Withdrawing money during the surrender period, which can last up to 10 years, results in high fees of 10% or more of the withdrawn amount. Because annuities are designed for retirement, withdrawals before age 59 ½ lead to a 10% penalty.

Thoroughly understanding indexed annuities helps determine whether one is right for you.

What Is an Indexed Annuity?

 An indexed annuity is a contract between you and an insurance company that pays interest based on a market index, such as the S&P 500. (Standard & Poor's stock market index tracks the stock performance of 500 leading companies listed on US stock exchanges.) The principal remains protected, offering a minimum return even in down markets. Although gains can be significant when markets perform well, contract provisions limit the upside.

How an Indexed Annuity Works

The owner, or annuitant, can earn higher yields through an indexed annuity than a fixed annuity. They also receive protection against market declines:

• The rate on an indexed annuity is calculated from the annual index gain or its average monthly gain over a year.

• If the stock index decreases, the insurance company provides a minimum rate of return, typically 2%.

• The contract does not lose value when the market performs poorly.

• Gains are limited to the contract provisions, including participation rates and rate caps.

Participation Rate in an Indexed Annuity  

An indexed annuity typically allows a percentage of the potential gain rather than the full benefit of the index’s rise, known as the participation rate. For instance, if the stock index increases by 15%, an 80% participation rate would credit a 12% yield. The participation rate is typically between 80% and 90% in the first 2 years of the contract, then declines. 

Yield and Rate Cap in an Indexed Annuity  

The rate cap typically ranges from 2% to 15%, subject to change. For instance, a 4% rate cap means the credited yield cannot exceed 4%, even if the index gains exceed this percentage.

The yield or rate cap in an indexed annuity can further limit the amount credited to the account during the accumulation phase. For instance, in the example above, the 80% participation rate that reduced the 15% index gain to 12% for the indexed annuity would be further reduced to 4% with a 4% rate cap in the contract.

How Adjusted Values Impact an Indexed Annuity  

The insurance company periodically updates the indexed annuity account value to include any gain from that period. Multiple methods are used to adjust the account value, such as a year-over-year reset or a point-to-point reset, which incorporates 2 or more years’ worth of returns.

Downsides of an Indexed Annuity

The downsides of an indexed annuity include the following:

• You do not get the full upside when the market performs well.

• The participation rate and rate cap limit your gains.

• The guaranteed rate of return might not keep pace with inflation, causing you to lose money.

• Although each US state has a guaranty fund to cover clients’ losses if an insurance company becomes insolvent, the funds might not cover every contract, and the recovery process can be complex and time-consuming.

*This information is for educational purposes only.

Are you considering purchasing an indexed annuity? Let me know in the comments!