Indexed annuity

What Is an Indexed Annuity?

An indexed annuity is a contractual agreement between an investor and an insurance company that offers returns linked to the performance of a specific market index, such as the S&P 500, while also providing a measure of principal protection. This financial product falls under the broader category of retirement planning instruments, designed to provide a stream of income, often during retirement. Unlike direct investments in the index, an indexed annuity does not directly hold the underlying securities. Instead, its credited interest is based on a percentage of the index's gains, usually subject to various participation rates, caps, or spreads. These products aim to offer more growth potential than a traditional fixed annuity but with less risk than a variable annuity. Gains within an indexed annuity typically grow on a tax-deferred basis until withdrawals begin.

History and Origin

Annuities have a long history, with their roots tracing back to Roman times, where they were used to provide lifetime payments to soldiers and citizens. Modern annuities, including indexed annuities, evolved as financial products offered by insurance companies. The concept of linking annuity returns to a market index emerged to address investor demand for market participation while retaining some level of capital preservation. Sales of indexed annuities, particularly equity-indexed annuities (EIAs) and registered index-linked annuities (RILAs), have seen significant growth over the past few decades. This growth has prompted increased scrutiny and updates from regulatory bodies to ensure appropriate disclosures for investors. For instance, in July 2024, the U.S. Securities and Exchange Commission (SEC) adopted new disclosure requirements and registration processes for RILAs and registered market value adjustment annuities, mandating that issuers register these offerings on Form N-4 to provide more tailored information to investors.¹³, ¹⁴, ¹⁵, ¹⁶, ¹⁷

Key Takeaways

• An indexed annuity links its returns to a market index, offering growth potential without direct stock market participation.
• They typically provide principal protection, meaning the initial investment is not directly exposed to market downturns.
• Returns are often subject to caps, participation rates, or spread margins, which can limit upside potential.
• Indexed annuities are designed as long-term retirement savings vehicles, often incurring surrender charges for early withdrawals.
• Earnings grow on a tax-deferred basis, with taxes becoming due only upon withdrawal.

Formula and Calculation

The returns credited to an indexed annuity are not a direct mirror of the underlying index's performance. Instead, they are determined by a combination of factors set by the insurance company. There isn't a single universal formula, as different indexed annuities use various crediting methods. Key elements that influence the credited interest include:

• Participation Rate: This is the percentage of the index's gain that the annuity credits to the contract. For example, if the index gains 10% and the participation rate is 80%, the credited gain would be 8% (10% x 0.80).
• Cap Rate: This is the maximum interest rate an indexed annuity can earn over a specified period, regardless of how much the underlying index gains. If the cap rate is 5% and the calculated return (after applying the participation rate) is 7%, the annuity will only credit 5%.
• Spread Margin (or Deduction): Some contracts subtract a certain percentage from the index's gain before applying it to the annuity. For example, if the index gains 10% and the spread is 2%, the credited gain would be based on 8%.

The specific indexing method also plays a crucial role. Common methods include:

• Point-to-Point: Compares the index value at the beginning and end of the annuity term.
• Annual Reset: Compares the index value annually, locking in gains each year.
• Averaging: Calculates the average of the index's value over a period, reducing volatility.

Interpreting the Indexed Annuity

Interpreting an indexed annuity involves understanding how its unique features translate into actual returns and risks. The primary interpretation revolves around how the contract credits interest based on the chosen market index and the various limiting factors, such as participation rates, cap rates, and spreads. If the index experiences positive growth, the indexed annuity aims to capture a portion of that upside, providing potentially higher returns than a traditional fixed annuity. However, these gains are often constrained by the cap rate, meaning that even if the index soars, the annuity's credited interest will not exceed this predetermined maximum.

Conversely, if the index declines, most indexed annuities offer a degree of principal protection, ensuring that the initial investment does not lose value due to market downturns. This downside protection is a key selling point, but it's important to recognize that it typically applies only to the principal and not necessarily to previously credited interest or fees. The trade-off for this protection is the limitation on upside potential and the complexity of calculating actual returns, which can differ significantly from the index's total return, especially since dividends are usually excluded from the index calculation.¹¹, ¹²

Hypothetical Example

Consider an investor, Sarah, who places an initial principal of $100,000 into an indexed annuity linked to the S&P 500. The annuity has a 75% participation rate and a 6% cap rate for annual gains, with a 0% floor (meaning no losses from index declines).

• Year 1: The S&P 500 increases by 10%.
  • Calculated gain: 10% (index gain) * 75% (participation rate) = 7.5%.
  • Applied gain (subject to cap): Since 7.5% is higher than the 6% cap, Sarah's annuity is credited with 6%. Her annuity value grows to $106,000.
• Year 2: The S&P 500 decreases by 5%.
  • Calculated loss: -5%.
  • Applied gain (subject to floor): Due to the 0% floor, Sarah's annuity value remains at $106,000. Her principal is protected from the market downturn.
• Year 3: The S&P 500 increases by 4%.
  • Calculated gain: 4% * 75% = 3%.
  • Applied gain (subject to cap): Since 3% is less than the 6% cap, Sarah's annuity is credited with 3%. Her annuity value grows to $109,180 ($106,000 * 1.03).

This example illustrates how an indexed annuity offers upside potential, albeit limited, while protecting the principal during market declines. It highlights the importance of understanding the specific features that influence returns when considering diversification strategies.

Practical Applications

Indexed annuities serve various purposes in individual financial planning, primarily within the realm of retirement planning. They are often considered by individuals seeking growth potential beyond traditional fixed-income investments but with greater stability than direct stock market exposure.

• Retirement Income: A common application is to accumulate funds for future retirement income. The tax-deferred growth allows earnings to compound without annual taxation until distributions begin, which can be advantageous over a long savings horizon.
• Capital Preservation: For those wary of market volatility but still desiring some linkage to market performance, the principal protection feature makes indexed annuities an attractive option. This appeals to conservative investors nearing or in retirement who cannot afford significant losses to their core savings.
• Supplementing Other Retirement Accounts: Individuals who have maxed out contributions to traditional retirement accounts like 401(k)s or IRAs may use non-qualified indexed annuities to continue saving for retirement on a tax-deferred basis.
• Estate Planning: Indexed annuities can also include death benefits, ensuring that a named beneficiary receives a certain amount, often the account value or a guaranteed minimum, upon the annuitant's death.

These applications highlight the role of indexed annuities in providing a balance of growth and protection within a comprehensive financial strategy.

Limitations and Criticisms

While indexed annuities offer benefits like potential for growth and principal protection, they also come with several limitations and criticisms that investors should understand.

One significant criticism centers on their complexity. The various cap rates, participation rates, and spread margins, coupled with different indexing methods (e.g., point-to-point, annual reset, averaging), can make it difficult for investors to fully comprehend how their returns will be calculated and to compare one product to another. The SEC and FINRA have both issued warnings highlighting the complex nature of these products and the potential for investors to receive lower returns than expected.⁸, ⁹, ¹⁰

Other limitations include:

• Limited Upside Potential: The participation rates and cap rates mean that even in strong bull markets, the annuity's credited interest will not fully match the market index's performance. This trade-off is the cost of downside protection.
• Exclusion of Dividends: Most indexed annuities calculate returns based solely on the price appreciation of the underlying market index, excluding dividends. Since dividends can contribute a significant portion of a stock index's total return, this exclusion further limits the actual return an investor receives compared to direct index investment.⁶, ⁷
• Surrender Charges: Indexed annuities are long-term contracts. If funds are withdrawn before a specified period (often 6 to 10 years), investors may incur substantial surrender charges, which can erode the principal or credited interest.⁵
• Liquidity Constraints: Due to surrender charges and the long-term nature of the contract, funds invested in an indexed annuity may not be easily accessible without penalty.
• Fees and Charges: Beyond the cap, participation rate, or spread, indexed annuities may have additional fees for riders or enhanced benefits, which can further impact net returns.

These factors underscore the need for careful consideration and thorough understanding before investing in an indexed annuity.

Indexed Annuity vs. Fixed Annuity

Indexed annuities and fixed annuities are both types of annuity contracts offered by insurance companies, but they differ significantly in how they generate returns.

A fixed annuity offers a guaranteed interest rate for a specified period or the life of the contract. The rate is typically declared in advance and does not fluctuate with market performance. This provides predictable, stable growth and maximum security of the principal. The trade-off is that the returns are generally lower and do not participate in market upside.

In contrast, an indexed annuity ties its returns to the performance of an external market index. While it typically provides protection against market losses to the initial principal, it offers the potential for higher returns than a fixed annuity if the index performs well. However, these market-linked gains are usually subject to various limiting factors like cap rates, participation rates, or spread margins. This means an indexed annuity offers a hybrid approach: less risk than a variable annuity but more potential upside and complexity than a fixed annuity.

FAQs

Are indexed annuities regulated?

Yes, all indexed annuities are regulated by state insurance company commissioners. Additionally, certain types, particularly registered index-linked annuities (RILAs), are considered securities and are also regulated by the U.S. Securities and Exchange Commission (SEC) and FINRA.³, ⁴

Can I lose money with an indexed annuity?

While the principal of an indexed annuity is typically protected from market downturns, you can still lose money through surrender charges if you withdraw funds early, or if fees and charges erode your gains, particularly if the market index performance is flat or minimal.

How are indexed annuities taxed?

Indexed annuities grow on a tax-deferred basis, meaning earnings are not taxed until you withdraw them. When payments begin in the payout phase, the earnings portion of the withdrawals is taxed as ordinary income. Withdrawals before age 59½ may also be subject to a 10% IRS penalty in addition to ordinary income tax.

Is an indexed annuity suitable for short-term savings?

No, indexed annuities are generally considered long-term investment vehicles, often used for retirement planning. Their long surrender charge periods make them unsuitable for short-term savings needs, as early withdrawals can incur significant penalties.

Do indexed annuities pay dividends?

Indexed annuities do not directly pay dividends like stocks. The returns credited to the annuity are typically based only on the price performance of the underlying market index and usually exclude any dividends paid by the securities within that index.¹, ²