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You’ve heard the term “indexed annuity” tossed around – maybe while mindlessly scrolling through retirement planning posts, reading financial media or chatting at a dinner party with your MBA friends (sounds fun!).

But before you get dazzled by promises of market-linked growth and downside protection, let’s take a closer look. Because while indexed annuities might sound like the best of both worlds, anytime you hear “win-win” when it comes to financial products, you should start asking questions.

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WHAT IS AN INDEXED ANNUITY?

An annuity is a contract with an insurance company. You give them money now, it grows on a tax-deferred basis and could be used to create retirement income later. Or, you give the insurance carrier money now, in exchange for some form of guaranteed income. For this discussion, we’re talking about deferred annuities, where you put money in the annuity before you need it, and it hopefully grows until it’s time to put the funds to use.

With a fixed deferred annuity, you’re guaranteed to earn at least a certain interest rate, for a specified period.

With a variable annuity, the value of your investment changes (up or down), based on the performance of selected mutual funds or other options (aka sub-accounts).

An indexed annuity is a type of fixed annuity that links your interest earned to the performance of a market index (like the S&P 500). But you’re not actually investing in the market, and that’s important to remember.

Unlike investing in a fund that tracks the same index:

• You won’t get dividends
• Your interest will be based on an interest crediting strategy
• Fees and spreads can eat into your returns

On the other hand, if the market goes down, you might have some protection from losses. Just to confuse things, there are two main kinds of indexed annuities:

• Fixed Indexed Annuities: These are not considered an investment by the SEC, so there is no prospectus and in most cases, your account value does not go down as a result of negative index performance.
• Registered-Linked Annuities (aka RILAs or Buffered Annuities): These contracts are considered an investment, do have a prospectus and your account value could go down if negative index performance surpasses the preselected “buffer” (for example, if the contract includes a 10% buffer, and the index had a negative 15% return for the period, your contract value would go down by 5%).

Getting complicated? Hold onto your hats; we’re just at the beginning.

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HOW DOES AN INDEXED ANNUITY WORK?

THE ACCUMULATION PHASE

During this phase, you put money into the annuity. You can either put a lot of money in at once, or smaller amounts over time. The insurance company tracks the index and credits your account based on its performance (with limits, which we’ll get to).

But let’s talk about liquidity. When you purchase the annuity, there will usually be a 7- to 10-year surrender charge period. If you cancel your contract during this period, the carrier will subtract the surrender charge from your contract value. This compensates the carrier for administrative costs for establishing the contract and the commission they paid to the agent or broker.

THE INTEREST CREDITING STRATEGY

Every so often during the accumulation phase, your interest will be calculated and credited based on the index value’s change. The amount of interest you earn is calculated based on the interest crediting strategy selected at the point of sale (And beware! These can also be changed at each anniversary).

Some common interest crediting methods include:

• Annual point-to-point. This method compares the index level at each policy anniversary date.
• Averaging. This method compares where the index started at the beginning of the time period to the average index value at a series of points during the time period (usually each month).

Once that calculation is complete, your interest is further adjusted per the terms of the contract. We’ll look at that next.

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HOW THE INTEREST YOU EARN COMPARES TO THE INDEX

There are a few key features to consider here.

• Participation Rates. The percentage of an index's returns that "count” toward your interest. For example, if your annuity has a participation rate of 80% and the index was up 10% during the time period, then the return credited to you would only be 8%.
• Caps. This is the maximum interest you can earn for the period, if the index had a gain. For instance, if the chosen index goes up 10% but your annuity has a cap of 7%, you’ll be credited 7%.
• Spreads. In addition to the participation rate or cap, some strategies also include a spread, which is an amount “taken off the top” first. For example, in the participation rate example above, the 10% index gain is reduced by the 1% spread, and then you apply the 80% participation rate, resulting in an interest credit of 7.20 (10% - 1% X 80%).

Before we move on, note that indexed annuity contracts allow the issuer to change the participation rates, caps and spreads each time the strategy renews (usually the contract anniversary). Since changing these features is one way a carrier can increase their profit, they often change them in their favor as time goes by. If you’re considering one, you should make sure you know the minimum participation rate, minimum cap and maximum spread allowed.

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INDEX OPTIONS

• S&P 500
• Dow Jones Industrial Average
• Nasdaq
• Other indexes that cover a portion of the market

Some indexed annuities give you a choice of which index you want to track. Once again, note that you don’t own an actual investment in the stocks tracked by these indexes (or in the indexes themselves, which is impossible).

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INCOME RIDERS ADD TO THE COMPLEXITY

Just when you thought annuities couldn’t get any more complex, let's talk about income riders. Many indexed annuities will include a rider that offers the contract owner the ability to receive an amount of annual income that is often guaranteed for life, even if the contract value has been depleted.

Income riders include a value that is used to calculate the potential amount of income, usually called the “income base” or “benefit base.” In most cases, this value grows differently than the contract value and the interest crediting strategy we covered earlier. The income base may earn a fixed amount of interest each year, for a specified period (for example, the first 10 years). This is commonly called a “roll-up.” Sometimes the benefit base will be increased to match the contract value, which is called a “step-up.”

The amount of income will be determined by multiplying the benefit base by a payout rate. The payout rate usually increases based on age and will also vary based on whether you have a single or joint life income and sometimes depending on level versus increasing income. Confused yet? Yeah, we weren’t kidding when we said it was complex.

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WHO COULD BENEFIT MOST FROM INDEXED ANNUITIES?

Indexed annuities are a type of retirement income annuity. They’re intended for retirement savers who are seeking a balance between growth and security. That said, there are other ways to get this balance that may be more appropriate and helpful in reaching retirement goals.

PROS OF INDEXED ANNUITIES

• Potential downside protection. You may lose less money (or no money) in a down market than you would have by directly investing in a fund that tracks the same index.
• The ability to participate in market gains. You could enjoy potentially higher returns than fixed annuities.
• Tax-deferral. Similar to conventional fixed annuities, the taxes on gains in indexed annuities are deferred until you withdraw money.

CONS AND RISKS OF INDEXED ANNUITIES

Indexed annuities are incredibly complex. And while they can promise market-linked growth with downside protection, they often deliver lower returns than other options and come with fees, surrender charges and limited flexibility.

• Participation rates: You only get a slice of the index’s gains.
• Caps: There’s a ceiling on how much you can earn.
• Spreads/margins: These fees reduce your credited return.
• Surrender charges: Want out early? You may pay for the privilege. Withdrawing principal from an indexed annuity during a certain time period – usually within the first six to 10 years after purchase – may result in fees.
• Tax penalties: Withdraw before age 59 ½ and Uncle Sam will probably want a cut.
• Insurance company risk: Your payouts depend on the issuer’s ability to keep paying. You can find financial strength ratings for an insurer online. And note that while all indexed annuities are regulated by state insurance commissioners, only those that are registered as securities are regulated by the SEC and FINRA.
• Withdrawals during a time period: If you take money out before the end of a given time period, you may not get all of the return from that time period.

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INDEXED ANNUITY VS. FIXED AND VARIABLE ANNUITIES

Indexed annuities share characteristics of both fixed and variable annuities. Generally, indexed annuities have more upside potential than a fixed annuity but less risk (and potential return) than a variable annuity.

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QUESTIONS TO ASK BEFORE BUYING AN INDEXED ANNUITY

The National Association of Insurance Commissioners offers a list of the questions you should ask before buying any annuity.

• Do I understand the risks of an annuity? Am I comfortable with them?
• How will this annuity help me meet my overall financial objectives and time horizons?
• Will I use the annuity for a long-term goal such as retirement? If so, how could I achieve that goal if the income from the annuity isn’t as much as I expected it to be?
• What features and benefits in the annuity, other than tax deferral, make it appropriate for me?
• Does my annuity offer a guaranteed minimum interest rate? If so, what is it?
• If the annuity includes riders, do I understand how they work?
• Am I taking full advantage of all of my other tax-deferred opportunities, such as 401(k)s, 403(b)s, and IRAs?
• Do I understand all the annuity’s fees, charges and adjustments?
• Is there a limit on how much I can take out of my annuity each year without paying a surrender charge? Is there a limit on the total amount I can withdraw during the surrender charge period?
• Do I intend to keep my money in the annuity long enough to avoid paying any surrender charges?
• Have I consulted a tax advisor and/or considered how buying an annuity will affect my tax liability?
• How do I make sure my chosen survivors (beneficiaries) will receive any payment from my annuity if I die?

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SHOULD YOU CONSIDER A FIXED INDEXED ANNUITY?

It’s important to ask yourself what you hope to accomplish with an indexed annuity. If the mix of potential market gains plus less downside risk is appealing, note that you may be able to get these benefits with other strategies – and with much less in the way of fees or loss of access to your money.

A financial advisor from ��Ѩ��Ƶ can be an invaluable resource to consult when deciding how to save for retirement. As a fiduciary, our advisors don’t receive commissions or incentives to sell any investments or other financial products. They can and will only recommend investments and strategies that are in your best interest. Before you make a decision or sign a contract, talk to us.