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Indexed Annuities: Comparing the Pros and Cons

Learn how indexed annuities work to provide retirement income that is based on the performance of stock market indices, including the pros and cons to consider.

If you’re getting close to retirement, chances are a salesperson has tried to sell you an annuity product.

There are several types of annuities, which are essentially insurance products.

While all annuities have certain aspects in common, indexed annuities have unique features that can be very complex.

Salespeople spin these complex factors to show you how they could benefit you.

The key is understanding how indexed annuities really work so you can determine whether they’re a good fit for you.

Here’s what you need to know about indexed annuities so you can decide for yourself.

What is an Indexed Annuity?

An indexed annuity is a type of insurance contract.

Annuities require you to pay money in a lump sum today or in several payments over time.

In exchange for those payments, the insurance company will make a stream of payments to you in the future.

In some cases, that stream of payments will last the rest of your life. In other situations, it may last a defined period.

Calculating the rate of return

What makes indexed annuities unique is how they measure the rate of return that gets applied to your balance.

Indexed annuities use a market index, such as the S&P 500, to make those adjustments.

You don’t usually get the returns of the index, though. Instead, that return is used to calculate the return you get after accounting for other factors.

Here’s how an indexed annuity works in detail.

How Do Indexed Annuities Work?

Annuities grow in value over time.

Accumulation phase

If you have a deferred annuity, you make payments over time to add to the balance. This is called the accumulation phase.

During this phase, the balance you have in the annuity changes according to the contract terms and the rate you earn based on the index and calculations.

Your balance grows from deposits you make, too.

Annuitization phase

Once you start receiving payments from the annuity, you enter the annuitization phase. Payments you receive reduce your balance.

Even during this phase, the balance in your annuity changes based on the contract terms and rate of return tied to the index.

What makes an indexed annuity unique is the rate of return you get based on the specified index.

Each annuity company and even annuity contract may have different terms. You must read them carefully and understand exactly how they work.

Ways to determine rate of return

Common ways to calculate the rate of return include a rate cap, a participation rate, a spread fee, and any riders you may have. These could be combined, too.

A cap limits the maximum gain you can earn.

For instance, there could be a 10% cap. If the index goes up 12%, you only get the 10%.

A participation rate means you get a percentage of the gain. If your participation rate is 50% and the index goes up 10%, your investment goes up 5%.

A spread fee is another method commonly used. This is a percentage that is subtracted from the index returns to get your return.

If the spread fee is 3% and the index went up by 5%, your investment only increases by 2%.

Riders

Riders can also affect your returns. Additional benefits result in extra costs.

If you add a rider that guarantees you a certain income, you can bet that will lower your returns elsewhere.

Other factors

Indexed annuities also reduce your returns in a less than straightforward way. They generally don’t include dividends in their index return calculations.

This lowers the overall return of the index and the rate of return your annuity gets.

You have to know the period the annuity company is using to make these calculations, too.

Some use a monthly period, while others use an annual period. This can impact the returns you get significantly depending on how your index performs.

These annuities may provide a benefit by limiting the downside risk, or the threat of losses in the markets.

The limits placed on gains may offset the insurance company’s losses from offering limited losses over the long term.

Pros

Indexed annuities have benefits that fit the needs of some situations.

Tax-deferred earnings

Annuities allow your earnings to grow tax-deferred. That means you don’t pay taxes on increases in the balance as you earn them.

You do have to pay taxes when you withdraw the money down the road, though.

Allows for growth

Indexed annuities allow your balance to grow over time based on the performance of an index and the terms of your contract.

This provides a more significant growth potential than a fixed annuity that only increases a set amount each year. That said, it comes with more risk, too.

May protect against losses

Annuities generally protect you from your balance decreasing due to the index decreases.

That said:

This comes at a cost.

Any caps, participation rates, spread fees, and riders likely impact just how much of those index earnings you get.

The insurance company is betting those limited gains will more than offset any losses they take in bad years.

Cons

Indexed annuities are far from perfect.

Extremely complex return calculations

Indexed annuities were not made to be easily understood. Whenever you find a product like this, you have to wonder what they’re hiding.

Technically, they’re not hiding anything. Everything is spelled out in your annuity contract.

Unfortunately, people may not always understand what all the terms mean.

Even if the salesperson explains everything perfectly, people may not know how that applies to long-term index returns.

Insurance companies can use several different methods to limit gains. They can also pick periods that benefit the insurance company rather than the consumer.

To make things more complicated, these confusing aspects could be combined. You may have a cap and a spread fee, limiting potential returns even further.

Tons of fees

Any type of annuity comes with many fees, but indexed annuities are even worse thanks to their index return calculations.

In addition to the caps, spread fees, and more mentioned above, you have to look out for other costs, too.

You may have to pay a mortality fee to cover the risks the insurance company faces for holding your annuity. This is usually around 1% but could be higher or lower.

If you want to take an early withdrawal, you may have to pay a steep surrender charge to get your money out.

The surrender fee period could last as long as a decade. These fees could end up costing you thousands of dollars.

You may be charged an administration fee or other fees depending on your contract. Read it carefully to discover every fee you may have to pay.

Salespeople get big commissions

One reason for the high fee structure is the commissions the insurance companies pay salespeople.

While it depends on the contract, a salesperson may get a commission that’s a few percent of the amount you deposit.

This commissioned sales structure hurts consumers because the salesperson’s and the consumer’s goals are not aligned.

The salesperson could steer you to the contract with the highest commission even if it isn’t the best fit for your situation.

Due to these products’ complexity, people may rely on the salesperson for advice on which to choose. Don’t do this without verifying with a fiduciary professional first.

When Do Indexed Annuities Make Sense?

A good investment plan may outperform an annuity, but most people purchasing annuities aren’t looking for the best performance.

Instead, they’re looking for a reliable income stream for their retirement planning needs.

Indexed annuities are less reliable than fixed annuities since fixed annuities essentially offer fixed interest rates and a guaranteed minimum income.

Indexed annuities do provide more growth opportunities, though.

They’re generally considered less risky than variable annuities, too.

Someone looking for some growth that understands the risks of potentially higher returns could be a good fit for an indexed annuity.

If you have closely examined and understand the annuity contract in question and it meets your goals, it may be a good fit for you.

Consult a Fee-Only Fiduciary Financial Advisor

The bottom line about indexed annuities is you have to watch out for yourself. One way to do this is by consulting a fee-only fiduciary financial advisor.

A fiduciary financial advisor must advise you based on your best interests. Other advisors may simply have to sell you a suitable product that could work but isn’t optimal.

A fee-only fiduciary financial advisor shouldn’t sell you an indexed annuity, though. Instead, you have to pay them for their time.

They can help you evaluate contract offers you already have or advise you on finding the best deal for your situation.

It may feel like you will lose money from paying a fee-only fiduciary advisor their fee.

However, the cost of advising a genuinely independent individual when considering complex financial contracts could easily save you thousands of dollars if they catch something you miss.

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