Indexed annuities have surged in popularity because of the way they incorporate features beyond those found in conventional fixed annuities. Similar to conventional fixed annuities, the taxes on gains in indexed annuities are deferred until you begin receiving distributions.
While all indexed annuities are regulated by state insurance commissioners, only those that are registered as securities are regulated by the SEC and FINRA. If the indexed annuity is a security, generally a prospectus will be delivered to you.
Indexed annuities are complex financial instruments, and retirement experts warn that such annuities include a number of features that may result in lower returns than an investor might expect.
Many indexed annuities are tied to broad, well-known indexes like the S&P 500 Index. But some use other indexes, including those that represent other segments of the market. Indexed annuities expose you to more risk (but more potential return) than a fixed annuity but less risk (and less potential return) than a variable annuity. As a result, the return on these products may be higher or lower than the guaranteed rate of return on conventional fixed annuities.
The industry generally offers two types of indexed annuities—equity-indexed annuities (EIAs) and registered index-linked annuities (RILAs). Both EIAs and RILAs calculate rates of return based on the performance of one or more selected market index, but only EIAs offer a guaranteed minimum rate of return.
How Do They Work?
Indexed annuities have characteristics of both fixed and variable annuities. Their return varies more than a fixed annuity but not as much as a variable annuity.
The return on EIAs, which comes in the form of interest credited to the contract, typically consists of a guaranteed minimum interest rate combined with an interest rate linked to a market index. A market index tracks the performance of a specific group of stocks representing a particular segment of the market, or in some cases an entire market. Many indexed annuities are based on the S&P 500 or other broad indexes, but some use other indexes or may allow investors to select one or more indexes.
The guaranteed minimum interest rate usually ranges from 1 to 3 percent on at least 87.5 percent of the premium paid. As long as the company offering the annuity is fiscally sound enough to meet its obligations, you’ll be guaranteed to receive this return no matter how the market performs. (To find a list of firms that provide ratings of insurance companies, visit the SEC’s website.)
The return on RILAs also comes in the form of interest credited to the contract and an interest rate linked to a market index, but RILAs lack the guaranteed minimum interest rate found in EIAs. Instead, RILAs offer limited downside protection through the use of “floors” and “buffers” in exchange for capped upside potential.
What Is the Rate of Return?
Indexed annuity returns will depend on how the selected index performs but, in general, the rate of return for an indexed annuity doesn’t fully match the positive rate of return of the index to which the annuity is linked—and could be significantly less.
EIAs subject returns to contractual limitations in the form of participation rates, fees or caps.
Participation rates are the percentage of an index's returns that are credited to the EIA. For instance, if an annuity has a participation rate of 75 percent, then the index-linked returns would only amount to 75 percent of the gains associated with the index.
Some EIAs use a spread, margin or asset fee in addition to, or instead of, a participation rate. This percentage will be subtracted from any gain in the index linked to the annuity. For example, if the index gained 10 percent and the spread/margin/asset fee is 3.5 percent, then the gain in the annuity would be only 6.5 percent.
Interest caps, meanwhile, essentially mean that during big bull markets, investors won't see their returns go sky-high. For instance, if an index rises 12 percent but an investor's EIA has a cap of 7 percent, their returns will be limited to 7 percent.
Some EIA contracts allow the issuer to change the fees, participation rates and interest caps from time to time, which could adversely affect your return. Investors should read their contract carefully to see if it allows the insurance company to change these features.
RILAs use either buffers or floors selected by the contract owner to calculate rates of return, limiting both risk and reward.
Buffers are the percentage of loss the contract owner doesn’t want to absorb if the market index linked to the RILA’s performance goes down. Losses up to the buffer percentage are absorbed by the insurance company, but losses exceeding the buffer percentage are absorbed by the contract owner. For example, if the buffer percentage is set at 10 percent and the market index decreases by 15 percent, the contract owner only absorbs a 5 percent loss.
Floors are the maximum percentage loss the contract owner is willing to absorb if the market index linked to the RILA’s performance goes down. Losses up to the floor percentage are absorbed by the contract owner, but losses exceeding the floor percentage are absorbed by the insurance company. For example, if the floor percentage is 10 percent, the contract owner’s maximum loss is 10 percent even if the market index decreases by a greater amount.
Different indexed annuities use different methods for determining the change in the relevant index over the period of the annuity. These varying methods impact the calculation of the amount of interest to be credited to the contract based on a change in the index. The variety and complexity of the methods used to credit investors can also make it difficult to compare one indexed annuity to another. Under the terms of some indexed annuity contracts that are securities, your returns could be worse when the market index goes down, which may not suit your income needs.
How Accessible Are the Funds?
Indexed annuities are intended to be long-term investments, and getting out early may mean taking a loss. Withdrawing the principal amount from an indexed annuity during a certain time period—usually within the first six to 10 years after the annuity was purchased—may result in fees known as surrender charges and may also trigger tax penalties.
Also, under some contracts, if withdrawals are taken, amounts already credited from returns will be forfeited.
Surrender charges will reduce the value and return of your investment. The result: After paying surrender charges, depending on the returns and amounts forfeited, an investor may lose some of the principal invested by surrendering an indexed annuity too soon.
As with any investment, it's important to do your research and thoroughly review the contract for the product being offered to you to determine whether it meets your needs.