An indexed annuity is a hybrid product that contains features of both fixed and variable annuities. Like a fixed annuity, it guarantees that the account value will not drop below your initial investment. Like a variable annuity, it provides for compounded tax-deferred growth that is based on an increase in the underlying investments. The return earned on an indexed annuity is tied to a specific market index, most commonly the S&P 500. Indexed annuities are also referred to as equity-indexed annuities.
Unlike retirement investments that earn lower returns if the index to which they are tied drops, indexed annuities can provide equity-like gains without the potential for substantial losses. Because most are indexed to the S&P 500, indexed annuities actually offer instant diversity. If you're concerned about the low return on a fixed annuity and the volatility of a variable annuity, an indexed annuity could be the solution.
Advantages of Indexed Annuities
Indexed annuities offer many advantages over traditional retirement investment vehicles. The potential for equity-like returns, the guarantee of principal, a death benefit for beneficiaries, limited losses, and the possibility of guaranteed lifetime income. Indexed annuities can play an important role in your retirement account or as part of your savings plan. Because indexed annuities offer tax-deferred growth and no annual contribution limits, they can be very useful if you are younger and maxed out your retirement account contributions. Indexed annuities are also well suited for older investors who wish to receive a lifetime stream of guaranteed income.
Indexed Annuities and Interest
One of the greatest challenges of buying indexed annuities is determining which interest crediting method should be chosen. When the contract is annuitized, the indexed annuity owner has a choice of the high-water mark method, the point-to-point method, or annual reset method. It's a difficult choice because interest rates and earnings can fluctuate greatly throughout the year. In order to determine which method is right for you, it's a good idea to take a look at how each method has done over the previous three, five, or 10 years. While past performance never guarantees future performance, it will at least give you an idea of how different the results can be over time.
The high-water mark method calculates the return by taking several points during a 12-month period and then uses the highest mark to compare the previous year to the next. The point-to-point method compares two points during the 12-month term. While the points differ among contracts, the two most common are at the start of the term and the end of the term. The difference between the starting and ending point is used to calculate earnings. The annual reset method takes the difference from the beginning of the first year of the contract to the end of the first year, and then uses the end of each subsequent year.
The Participation Rate Affects Return
After you've had a chance to review the variance in return among the three methods of interest calculation, you'll need to adjust the returns based on the participation rate. It's this rate that determines how much of the gain will be credited to your account. In other words, it's the percentage of the account that "participates" in the gain. And that number can have a significant impact on the total return. If the participation rate is 70% and the annual increase of the S&P 500 is 5%, the amount of the gain would be 3.5%. Life insurance companies figure the total return by multiplying the participation rate by the increase in the index. In this example, 70% is multiplied by 5%. 3.5% may not seem like a large gain, but it might be more than is offered on a certificate of deposit, savings, or money market account. However, if the index increases by an amount larger than 5% the following year, the percentage credited to the account would be larger. This does not happen with a CD or with a fixed annuity.
Indexed annuities can also have caps on the highest index increase that will be credited. For example, regardless of the amount of the increase in the index, the highest rate allowed is capped at 8%. Even if the index rises 15%, the maximum amount that is used as the multiplier is 8%. As the stock market has increased on average 10% per year for the last 70 years, you'll want to carefully consider whether you want to be locked into a contract that limits your earnings. Annuities are a balancing act. You need to balance safety with returns, just as you do with any investment.
Minimizing Losses with Indexed Annuities
One of the biggest changes to indexed annuities recently has been the ability for investors to minimize losses. Most life insurance companies today offer indexed annuities with a floor below which losses won't occur. For example, if the floor is set at 1%, but the index drops 5%, the loss will be limited to 1%. This loss minimization feature provides a big advantage over other retirement savings plans, as it ensures both participation in the gains of the index but reduces exposure to risk. Risk-averse and retired investors especially can benefit from an indexed annuity that has a floor rider. And, as inflation is another significant strain on purchasing power, the ability to continue the growth of assets after retirement provides additional financial stability.
Guaranteed Lifetime Income
Financial planners use the term "longevity risk" to indicate a person's risk of outliving assets. Most believe that longevity risk and inflation are the most significant risks an investor has. The Internal Revenue Service expects that today's 70-year-old will live to be 87, which is a lot longer than the average life expectancy of 78. It's clear that retirement savings must last much longer than most of us expect. With an indexed annuity, the risk of outliving your assets is transferred to the insurance company. In exchange for the amount of the premium you pay, the insurance company will provide guaranteed lifetime income or income for a specific amount of time. Even if you live to age 75, 80, 90, or beyond, owing an annuity will ensure that your retirement is provided for at least to some degree.
Indexed annuities can also be structured to provide guaranteed income to a surviving spouse after your death. Or, if you prefer, the annuity can be purchased with a death benefit. It will pay the balance between the amount of principal that has been paid out and the amount of premium used to purchase the annuity if you die before the entire premium amount has been paid out.
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