Understanding Indexed Annuities

There is a reason why annuities are appealing financial products. They remove the uncertainty from retirement income by guaranteeing an annual sum. However, do the costs outweigh the benefits? This is a closer look at indexed annuities and what experts say about them. A financial advisor can help you assess whether an indexed annuity’s features align with your goals and overall retirement strategy.

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What Is an Indexed Annuity?

An annuity is an agreement between you and the financial institution that you buy the annuity from, which is typically an insurance company. It pays you a certain amount of money each year, as outlined in the terms of the agreement, along with the corresponding fees due to the insurance company.

However, if you buy an indexed annuity, your funds are invested, allowing them to grow over the distribution period.

As a result, indexed annuities are often called equity-indexed annuities because they are indexed to equities.

How Indexed Annuities Work in Practice

When you buy an indexed annuity, you can make a lump sum payment or a series of payments to the insurance company. In return, the company promises to credit your account according to the performance of a chosen market index, such as the S&P 500.

However, unlike the direct ownership of stocks, you do not buy shares in the index. Instead, the insurer uses its own investment strategies to back the annuity while applying contract terms that limit how much of the index’s growth you actually receive.

The participation rate is one of the main factors that shape your returns. If your contract sets an 80% participation rate, you will earn only 80% of the index’s gains, even in years when the index performs strongly.

Some annuities also impose a cap on returns. For example, if your contract has a 6% cap and the index rises by 12%, your credited gain will stop at 6%, regardless of the participation rate. These restrictions enable insurers to control risk and preserve their ability to guarantee your principal.

Indexed annuities often include a floor, which protects you from losing money during market downturns. If the index drops, your contract may credit no gain but will not reduce your principal. Some annuity contracts even promise to pay a small minimum return, such as 1% or 2%, during negative years. This safety feature is what makes indexed annuities appealing to investors who want some growth potential without the risk of market losses.

The final outcome depends on the full set of terms. This includes annuity fees and surrender charges, which can reduce your net earnings if you withdraw early. While the mechanics may seem complicated, the key idea is that indexed annuities trade a portion of the market’s upside for the guarantee that you will not lose principal in bad years.

Understanding how these limits and protections work together is crucial when determining whether this type of annuity fits into your retirement strategy.

Pros and Cons of Indexed Annuities

Indexed annuities are marketed as a way to earn market-linked returns on retirement savings, but they come with both advantages and drawbacks.

Insurance companies often pitch indexed annuities as a great opportunity to earn returns on the money you have saved for retirement. The insurance company will take your money and invest it in an index fund that tracks the S&P 500. But what are the pros and cons of this strategy?

For one thing, the returns earned on an equity-indexed annuity are not comparable to the returns from a lump sum investment in a low-fee index fund that also tracks the stock market. This is because insurance companies deduct fees and, in some cases, will cap your earnings.

In a good year, the stock market makes gains. However, depending on the terms of your indexed annuity, your money may not grow as much as it would in the stock market. You could see only 80% of the stock market gains, depending on the participation rate for your indexed annuity. This ultimately determines the percentage of stock market gains you will earn. If your gains match the gains of the index, your participation rate is 100%.

Some indexed annuities come with a rate cap. If you have an indexed annuity with a rate cap, you will not be able to earn yields above that cap, no matter how well the stock market performs in a given year.

On the other hand, indexed annuities do not lose value during a market downturn like you do with investments in an index fund. Your insurance company may set terms preventing gains during market downturns, but it will not withdraw funds from your annuity. Some insurance companies will pay out a small yield during a market downturn, which helps take the sting out of inflation.

Bottom Line

Before buying an indexed annuity, make sure your advisor acts in your best interest and understand the trade-offs between security and cost.

If your financial advisor recommends that you purchase an indexed annuity it’s worth doing plenty of research before you make your decision. Does your advisor have a fiduciary duty to put your interests first? If not, he or she might be recommending the indexed annuity to get a kickback or commission, not because it’s the best fit for your retirement. Like other annuities, indexed annuities offer a trade-off between security and cost. It’s important to understand those trade-offs before you put your retirement savings on the line.

Retirement Planning Tips

A financial advisor can help you manage risk for your retirement portfolio. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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