Best Index Annuity
How to Find the Best Index Annuity
Index annuities can be the best of both worlds if they have favourable terms. A good index annuity has a high participation rate, high guaranteed minimum rate, low administration fees, high rate cap, and an annual reset provision. When reviewing contracts, weigh all of these factors holistically, as each insurance company strikes a unique balance.
Factors to consider when shopping for an index annuity include:
- Participation Rate
- Minimum Rate
- Cap Rate
- Crediting Methods:
- Annual Reset
- High Water Mark
- Administration Fees
- Vesting Schedule
High Participation Rate Index Annuity
The participation rate is the percentage of growth you receive on positive years. The higher the participation rate, the more you gain from an index’s growth. Small variations in this factor can significantly impact returns, so be sure to find the highest possible. Typical participation rates range from 50%-90% depending on other factors.
Let's see how participation rate affects returns. Let's compare two identical S&P 500 linked annuities, except annuity A has a 50% participation rate while annuity B has 90%. If we invested $100,000 in both and the S&P 500 rose 14%, account A would have $107,000 while account B would have $112,600. A $5,600 or 40% difference.
Because most index annuity earnings stem from moderately positive annual growth, getting a bigger piece of the pie via high participation rate is priority one.
High Minimum Rate Index Annuity
Every index annuity features a minimum rate that you receive during poor-performance years. The minimum rate serves two roles: 1) to protect against potentially catastrophic loss, and 2) to generate moderate growth. Function #1 is far more important and comes for "free" with any index annuity contract. Function #2 is a nicety, but shouldn't be prioritised over a participation rate.
A typically index annuity contract will stipulate a 1-3% minimum rate. Obviously look for the highest rate you can find, but this factor isn't nearly as significant finding a high participation rate. Even a 1% minimum rates serves the purpose of preserving capital.
Let's take a look at how an index annuity protects capital during down years. Suppose we invest in an S&P 500 linked annuity with a 50% participation rate. Suddenly the market turns sour and the S&P 500 drops 40% over the next year. Do you lose 20% of your investment? No! The minimum rate guarantees that even during the worst market crash you’ll still be earning money. If our contract stipulated a 2% guarantee, that's how much we'd earn this year.
High Cap Index Annuity
One way the insurance company pays for covering your losses during down years is by capping maximum earning during extraordinarily up years. This comes in the form of a rate cap. If the S&P 500 shows a 24% gain and the contract stipulates a 10% cap, total earnings will be 10% as opposed to 12% (assuming 50% participation rate).
Avoid a rate cap or find one as high as possible. On average the S&P 500 grows 14% per year, so avoid contract provisions that eat into this baseline. Caps above 14% are tolerable as long as they're counterbalanced by other favourable provisions, like a high participation rate. Generally speaking, it's preferable to extract more from moderate-growth years (via a high participation rate) than to hope to make a killing on years where the S&P 500 jumps 50%.
Annual Reset Provision
Index annuities use one of three common crediting methods to calculate annual returns: 1) annual reset, 2) point-to-point, and 3) high water mark. Each crediting method has it's own pros and cons depending on market conditions, but as a rule of thumb, the annual reset is best for most investors.
An annual reset provision insures that your account balance never drops below the previous year, which is raised annually.
Here's how it works: at the beginning of the contract term the S&P 500 is measured. In one year — on the anniversary date — the S&P 500 is measured again. The difference between the two measurements determines that year's yield. Supposed the S&P 500 rose 20%. With an annual reset provision your account would be credited with 20% minus participation rate and cap, and the measurement for next year would be reset to the resulting amount. The previous year's earning are secured because the account balance could not drop any lower.
Don't Just Shop, Implement a Solid Retirement Strategy
Purchasing an annuity is a big decision. Online research is a good start, but prudent investors should discuss all their options and risks with an independent financial advisor. Request a free, no-obligation consultation today, along with a report of current rates on brand-name annuities.Speak with an advisor over the phone about annuities for FREE.
Low Administration Fees
Some index annuities assess an annual administration fee in the range of 1-2%. This fees is levied by insurance companies to cover overhead and allows them to give higher participation rates, sometimes even as high as 120%! The administration fee is always deduced from principle and assessed regardless of index performance. It's advisable to avoid fees above 1.5%.
Favourable Vesting Schedule
Index annuities can be less liquid than their fixed or variable counterparts. If you plan to make withdrawals before the contract term elapses, look for a lenient vesting schedule. The vesting schedule determines how much of the collected earning you can keep with a premature withdrawal. And while most of your principle can be withdrawn, doing so could forfeit earnings.
A typically vesting schedule might look like this:
- Year 1: 0% earnings kept
- Year 2: 20% earnings kept
- Year 3: 40% earnings kept
- Year 4: 60% earnings kept
- Year 5: 80% earnings kept
- Year 6+: 100% earnings kept
In the above example, earnings are penalized depending on how long the annuity was held prior to making early withdrawals. When treated as a retirement savings instrument, the index annuity's vesting schedule is a factor of diminished importance in the overall quality of the contract.
A licensed index annuity specialist can provide a comprehensive quote comparison of the best indexed products currently on the market. Request Rates Now.