Indexed annuities have become more popular in recent years. This appeal may be due to features that can help protect the principal while also participating in market gains.
That’s an attractive combination, but indexed annuities are complex products and not appropriate for every investor. It’s important to understand how they work and the options you may have if you decide to purchase an indexed annuity contract.
Two Return Rates
Like all annuities, an indexed annuity is a contract with an insurance company that offers an income stream in return for one or more premium payments. Payments may begin right away (immediate annuity) or at a future date (deferred annuity) and are paid over the life of the contract — the owner’s lifetime, the lifetimes of two people, or a specific number of years. Of course, any guarantees are contingent on the financial strength and claims-paying ability of the issuing insurance company.
An indexed annuity offers a minimum rate of return (typically 1% to 3%) with a potentially higher rate based on the performance of a specified market index (e.g., the S&P 500). If the market has a down year, you would receive at least the minimum return (contingent upon holding the annuity until the end of the contractual term). If the market has an up year, you would receive a higher return, calculated in one or more of the following ways, based on the performance of the index.
Participation rate. Determines how much of the index gain will be credited to the annuity. For example, a participation rate of 80% means the annuity would be credited with 80% of the gain experienced by the index.
Spread/margin/asset fee. May be assessed in addition to, or instead of, a participation rate. For example, if the index gained 10% and the spread/margin/asset fee is 2.5%, then the gain in the annuity would be only 7.5%.
Interest-rate cap. The maximum rate of interest the annuity will earn. For example, if the index gained 10% and the cap rate was 6%, the gain in the annuity would be 6%. Index performance generally does not include dividends, and the way in which the performance is measured may vary, depending on the contract (see chart). Participation rates, cap rates, and other fees are set by the insurance company; some companies reserve the right to change these provisions either annually or at the start of each contract term. These types of changes could affect the investment return.
Most annuities have surrender charges that are assessed if the contract owner surrenders the annuity during the early years of the contract. However, some indexed annuities allow withdrawals of up to 10% per year without surrender charges. Of course, any withdrawals will reduce the principal, and withdrawals before the end of an index period will receive no interest for that period. Early withdrawals prior to age 59½ may be subject to a 10% federal income tax penalty.
Like all annuity contracts, indexed annuities have rules, restrictions, and expenses. Depending on the guarantees of the issuing company, it may be possible to lose money with this type of investment. Be sure to review the contract carefully before deciding whether to invest.
The S&P 500 index is an unmanaged group of securities that is widely recognized as representative of the U.S. stock market in general. You cannot invest directly in any index and do not actually own any shares of an index. Past performance is no guarantee of future results.
The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. Copyright 2015 Emerald Connect, LLC.