An Index annuity is an interesting twist in the world of annuities. It has many of the attributes of a fixed annuity and some aspect of a variable annuity. It is marketed by insurance agents as being both, depending upon the sophistication of their audience. Legally, an index annuity is a fixed annuity. However, to understand why this is true,we first need to review particular aspects of fixed and variable annuities.
Fixed and Variable Annuities
We don’t need to review items that are similar between fixed and variable annuities. These would include making contributions, withdrawal rules, taxation of withdrawals or fees ; though fees are higher under variable contracts. The area we want to focus on is the accumulation phase of the contract and how interest and investment earnings are credited to the contract.
In a fixed annuity, your contributions are credited with a fixed rate of interest. The insurance company guarantees that you will not lose any principal, nor receive less than the stated interest rate. This is one of the big selling points of a fixed annuity. You have certainty and guaranteed returns, even though you always wish the interest rate was higher. Since fixed annuities carry a fixed interest rate, they are not considered securities and do not come under the rules and oversight of the Securities and Exchange Commission.
In a variable annuity, your contributions receive investment earnings, but these are not guaranteed. You select your desired investments from a variety of mutual funds, usually high quality stock and bond funds. In this way, you have the advantage of potentially higher investment gains, and, therefore higher eventual annuity payments when you retire. Of course, you also have the potential of earning reduced investment returns due to drops in the stock market. However, over long periods, it is expected that your investment returns should outperform a fixed interest rate. Due to the exposure to the stock market, the variable annuity contract is subject to the rules and oversight of the SEC.
The Indexed Annuity
Index annuities are also known as equity indexed annuities since their investment returns are usually tied to the performance of equity or common stock investments.
An index annuity is a fixed annuity that has some relationship to a variable annuity. During the accumulation years of the contract, you receive a guaranteed interest rate which is reset periodically. On the surface, it looks just like any other fixed annuity.
However, during the accumulation phase, the interest rate to be credited is based on the investment returns of a basket of stocks or a stock index, such as the S&P 500 Index. The insurance company looks at the returns of this index and calculates an interest rate that produces a similar return. This interest rate is set and guaranteed for a certain period of time, such as 1, 3, 5, or7 years. A new rate is then calculated based on the returns of the stock index and applied for the following period.
The insurance company usually guarantees a minimum rate of interest that will be credited to the contract. This rate will be set relatively low, but it does give you the assurance that you can never lose your principal in case of a severe downturn in the stock market.
The Participation Rate
The insurance company does not provide you with the minimum guarantees and actual guaranteed rate without their getting paid for these benefits. So, you can’t simply look at the return of a stock market during a certain period and calculate your interest rate yourself. First, you won’t receive the entire return. The insurance company states a participation rate which is the percentage of stock market return that you will get. This rate might be 70%, 80% or 90%. So if the S&P 500 rises 4% in a given period, they may consider 3.2% (.80 times 4%) when calculating your interest rate at the reset date. The higher the percentage, the closer your interest rate will reflect the actual returns of the stock market investments.
Methods of Calculating Interest
There is considerable difference in how each insurance company calculates your interest rate based on stock market performance. There are 3 standard methods that may be used by the insurance companies.
- Annual Reset or Rachet Method – This method is a calculation of stock market performance between the beginning of the year and the end of the year, and it locks in the increases. Possible decreases in market performance the following year will not affect interest you have already received. So, this method of calculating your rate may produce greater interest when the market index is moves up and down a lot during the reset period. On the other hand, to reflect this potential for greater interest, you may receive a lower participation rate under this method. Also, many companies using this method impose an interest rate cap.
- The High Water Mark Method – This calculation will look at the highest level of the stock index during the year, and compare his point to the start of the next year. Interest may be higher with this method if the index is high at the beginning of the year and falls later in the year. However, interest does not get credited until the end of the reset period. So, if you terminate the contract prior to the end of the term, you will not get the higher interest for that period. Use of this method may also reduce the participation rate and impose an interest rate cap.
- The Point-to-Point Method – This method calculates the change in the stock index between values at the beginning and end of the year.But interest is not credited until the end of the reset period.You will probably get a higher percentage rate under this approach, which could be several years.
You may get hit with a host of fees and expenses. Some companies will impose management fees which are calculated as a percentage of your account value. These fees will be taken your of your earnings. Others will advertise that they have no administrative fees, but they impose higher investment management fees.
The areas of expenses, management fees and other negatives to your account must be reviewed, understood and compared to ensure you get the best deal.
Advantages of an Indexed Annuity
These annuities are designed for conservative investors who want exposure to stock market investments, but cannot afford a large drop in their assets. Older investors nearing their retirement age may consider his type of annuity to get the stock market participation without fearing loss of principal. The indexed annuity may also be appropriate for high income investors who are over the maximum limits in their other retirement plans.
Understand and Compare the Contracts
The contract provision above can be found in all index annuity contracts. However, the provisions come under different names, and the will be slightly different among the insurance companies. You need to understand each provision and compare among the various contracts. You are investing for your retirement and you need to ensure you know what you are getting for your long term commitment.