Understanding Indexed Annuities

If you own or have ever contemplated owning an indexed annuity, which are still referred to, on occasion, as an equity indexed annuity, you are on the right page.  These complex contracts can be difficult to understand and are even misunderstood by many of the agents who sell them.  We want to make it simple for you to understand what an indexed annuity is and what it can do, and more importantly, what it can’t do. 

What Is an Annuity?

First of all, an annuity is a contract which promises a fixed sum of money will be paid to someone (the annuitant) over a specific period of time, often the lifetime of the annuitant.  That being said, not all annuities are guaranteed to pay out the entire accumulated amount of money accrued.  Some annuities only pay for a certain period of time, or a certain amount of money and are not required to continue to pay out over an entire lifetime.

It used to be that a financial planner or advisor would recommend a fixed annuity to guarantee their client would have a dependable income for their entire life time.  But the world is changing. Some even predict that, “Financial planners are quickly being outsourced to planning software, apps, robo-advisors and investing algorithms.” But regardless of what happens to financial planners or advisors, what you do to ensure you won’t run out of money during your retirement is still important. So, pay close attention as to why an indexed annuity may not be the product you are looking for to provide guaranteed income for a lifetime. 

What Is an Indexed Annuity?

Equity indexed, or indexed annuities, are fixed annuities where the rate of interest earned is linked to the returns of a stock index such as the S & P 500.  Indexed annuities appeal to people who what to earn a higher rate of return but also what to have some protection for any downside risk the market may throw at them. Still, these annuities are complicated contracts and shouldn’t be entered into lightly. 

It is true that indexed annuities have the potential to offer a lower risk to someone compared to directly investing money in the underlying index itself.  Yet, indexed annuities by no means guarantee that your money can’t be lost after purchasing them.  Here are a few reasons why:

  1. During the accumulation phase of an indexed annuity, usually 10 years sometimes longer, there is a surrender or early withdrawal penalty which would apply if you were to access your money
  2. Accessing your money during this time period could not only cost you surrender fees but you could also end up paying a 10% penalty to the IRA.
  3. The participation rate of an indexed annuity, depending on how frequently it is altered and how it is initially set up, can reduce the growth experienced in an indexed annuity significantly
  4. Depending on the type of index being tracked by the indexed annuity, there could be a lack of growth from one period to the next period when the interest is actually accounted for in the accumulated value of the annuity
  5. Different equity indexed annuity contracts post interest to the accumulated value of the annuity at different times and frequencies creating a possible confusion as to when the interest reflected in the index is actually deposited into the accumulated value of the indexed annuity
  6. Premium fees reduce the potential interest growth as the money paid in fees never has the opportunity to participate in the interest rate of the underlying index
  7. Finally, as with any investment which depends on market movement to generate value, there is the risk that volatility can limit growth.  Here is where an equity indexed annuity, or as more commonly called, an indexed annuity, can actually offer some protection:
  8. By offering a guaranteed flat interest rate of 0%-1% an indexed annuity contract can protect the annuity owner from suffering a negative interest earnings rate which would detract from their accumulated value of the annuity, during a bear market
  9. This guaranteed rate, however, typically only applies to 90% or less of premiums paid for the indexed annuity
  10. At the same time the capped earnings rate of an indexed annuity product, (10-15% typically) significantly reduces the potential interest earnings accumulated in an indexed annuity during a bull market.

Is an Indexed Annuity the Same as a Variable Annuity?

Variable annuities are different from indexed annuities. Variable annuities have a direct investment portion of their accumulated value invested in stocks or equities.  Indexed annuities, on the other hand, only mirror the interest returns of an index of stocks like the S & P 500, the Russel, the DOW, or some other stock index.  Variable annuities are considered an investment, and therefore can only be sold by a registered financial planner, or investment advisor or their representative.

Indexed annuities are contracts with an insurance company, but that doesn’t mean you don’t need to exercise due diligence when you are considering the purchase of an indexed annuity.  The contract provided with an indexed annuity does NOT guarantee that you can’t or won’t lose money. Don’t leap before you carefully analyze an indexed annuity contract thoroughly.  By knowing and understanding every aspect of an indexed annuity contract you could save yourself a lot of money, not to mention a lot of heartache later on when you are planning to use the money for yourself or a loved one.

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