The nice part about a classic fixed annuity is that the insurance company guarantees the return of your investment and a constant payout if you choose to annuitize. But with a long retirement ahead, inflation could eradicate the benefit of fixed payout by reducing its purchasing power. Should you consider indexed annuities for your potential to offset inflation?
Indexed annuities are generally complex financial instruments that have characteristics of both fixed annuities along with variable annuities. Their return can vary more than a fixed annuity, but not as much as a variable annuity. So indexed annuities have more volatility (but more potential return) than a fixed annuity.
Indexed annuities offer a minimum assured interest rate combined with an interest rate linked to a well known market index (such as the S&P 500 or Russell 2000). Indexed annuities can potentially earn a greater return than traditional fixed annuities when the stock market is rising.
Indexed Annuities guarantee
The guaranteed minimum annual simple interest for indexed annuities is typically 2.7%. But beware that if you give up indexed annuities early (i.e. prior to the end of the term, typically 10 years), you may have to pay out a significant surrender charge that will reduce and sometimes eliminate any return (plus a 10% tax penalty in case you're under age 59½). Additionally, if you forfeit your annuity prior to term, you could possibly give up your participation in a stock market growth.
How do indexed annuities participate in the market index?
Indexed annuities have interest credited using an equation based on changes in the index to which the annuity is linked. The interest crediting system (detailed in your annuity contract) decides how the additional interest, in the event that any accrues from market increases, is calculated and also credited. Many indexed annuities use the S&P 500 but some allow investors to choose one or more indexes. Typical crediting methods are:
• Participation Rates where they will often set the participation rate at 75%, so your annuity is credited along with 75% of the gain experienced by the actual index. Example: the S&P climbs by 12% for the year so your annuity gets 9% interest (12% x 75%).
• Spread/Margin/Asset Fee where a spread or asset fee, in addition to, or instead of, a participation rate - is deducted from index's gain before the remaining is credited to the indexed annuity. Example: the S&P climbs by 12% and you get that minus a spread of 5%, or 7%.
• Interest Rate Caps in which they put a cap or perhaps upper limit on your return. Therefore the cap is 8% nevertheless the index gain is 12%, then simply 8% is available for the indexed annuity return.
How the index change is evaluated may differ with the insurance company. Some measure yearly changes at year's end, some measure from a specific time since start of contract, some average the actual index change throughout the year. Indexed annuities are complex if not fully studied.
Also insurance companies might change participation rates, cap rates, or even spread/asset/margin fees either annually or perhaps at the start of the next contract time period. While other insurance companies will guarantee that these figures remain unchanged during the entire term of their indexed annuities. So read your agreement carefully to see if and when this allows the insurance company to change these factors. Because of all these parameters pertaining to measuring gain, it's difficult to for any consumer to compare different indexed annuities.
Take note: If there is no increase in the underlying market index (e.g. the S&P 500) during the designated term, investor will get only the minimum guaranteed rate subtracting expenses. With indexed annuities, withdrawals during the vesting period could potentially cause any and all gains not to always be realized. Guarantee is subject to statements paying ability of the insurance company. The buying annuities should be considered a long term investment. Withdrawals are subject to taxes as ordinary income and withdrawals ahead of age 59 ½ are be subject to 10% penalty. Indexed annuities have benefits but plenty of moving parts to understand