Indexed Annuities and Their Benefits

Unlike other retirement investments that can yield dramatically reduced returns if the market to which they are tied drop substantially, indexed annuities offer equity-like results without the potential for huge losses. The rate of return on an indexed annuity is most often tied to the Standard and Poor’s 500. The S&P 500 is comprised of the 500 largest companies in the United States. Together, these 500 companies represent almost every industry segment. So, while the performance of an indexed annuity is tied to the S&P 500, it represents a diverse investment as industry segments rarely move in tandem.

Indexed annuities offer several advantages over traditional retirement investment vehicles, such as equity-like returns, a potential guarantee of principal, a death benefit, limited potential for losses and guaranteed lifetime income. The amount credited to the annuity each year is based on three factors: The participation rate, a possible interest rate cap and the administration fee.

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The Participation Rate

The participation rate of an indexed annuity determines the amount of the gain that will be credited to the account. If the participation rate is 80% and the annual increase of the S&P 500 is 2%, the amount of the gain would be 1.6%. The life insurance company figures the return by multiplying the participation rate by the increase in the index. In this case, 80% is multiplied by 2%. While a 1.6% gain may not seem like much, it may be a larger gain than offered on certificates of deposit or traditional money market accounts.

Further, should the index enjoy an increase larger than 2% the following year, the percentage credited to the account would increase. This would not happen with a CD as CDs are interest rate sensitive.

An annuity contract will specify one of three ways in which interest will be credited in terms of the participation rate: The annual reset method, the high water mark method or the point-to-point method.

The annual reset method determines the percentage change in the underlying index from the beginning of the first contract year to the end of the first contract year and the end of each contract year that follows. The advantage of the annual reset method is that gains are locked in for each year, even if the index goes down during the year. The disadvantage is that if the gains are capped as described below, the amount of interest earned may be limited.

The high water mark method marks several points during the year and uses the highest mark as the comparison between years. The advantage is the potential for better gains. The disadvantage is that, along with the annual reset method, if gains are capped, they may be lower.

The point-to-point method determines the difference between two set points during the annual term, most often the beginning and the end. The advantage of the point-to-point method is that even with an interest rate cap, higher yields may be achieved. However, if the index is lower at one of the points than it was during the rest of the year, the return will be lower.

A Possible Interest Rate Cap

Some life insurance companies write annuity contracts with a maximum rate to be paid regardless of the gains of the index to which it is tied. In other words, if the highest rate allowed is capped at 5%, 5% would be credited to the contract even the index to which it is tied increased by 8%.

Administration Fee

The administration fee covers the costs the insurance company incurs to manage the contract. While an indexed annuity required less management than a variable annuity, there are still investments to be made and paperwork to be handled. The administration fee is most often a percentage and is typically deducted from the gains.

To minimize the fees charged, investors can choose “no-load” and “no surrender fee” annuities. These may be less expensive to purchase, but they will still more than likely charge management fees and a mortality and expense fee.

Minimized Losses

One of the most significant changes in indexed annuities in recent years has been the minimization of losses. Most insurance companies now offer indexed annuities with a floor, below which losses will not be realized. For example, if the floor is established at 0%, but the index drops 5%, the loss will be limited to 0%. This feature provides a tremendous advantage over retirement savings plans, as it ensures participation in gains and reduced exposure to risk.

For risk-averse investors, or for those who are at or very near to retirement age, an indexed annuity purchased with a floor rider is an excellent way to participate in the potential growth of the stock market while minimizing downside risk. And, as inflation presents yet another significant strain on purchasing power, the ability for continued growth of assets after retirement provides additional financial stability.

Guaranteed Lifetime Income

Financial planners use the term “longevity risk” to describe a person’s risk of outliving his or her assets. Most financial planners believe this is the most significant risk an investor has. In Publication 590, the Internal Revenue Service expects that today’s average 70-year-old will live to age 87, which is far longer than the average life expectancy that is quoted at age 78. So, retirement savings must last far longer than most people expect.

With an indexed annuity, the risk of outliving one’s assets is transferred to the insurance company. In exchange for the premium, the insurance company will provide guaranteed lifetime income. Even if the annuitant lives to age 80, 85 or longer, he or she is guaranteed a monthly income.

Indexed annuities can also be structured to provide guaranteed income to the surviving spouse when the original owner dies. Or, if the original owner prefers, he or she can purchase an annuity with a death benefit. The death benefit often pays the balance between the amount of principal that has been paid out and the amount of premium used to purchase the annuity.

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