When you’re buying a new home, you have two basic choices for a loan – a fixed rate or adjustable rate mortgage. But what if there was a third option that wasn’t as risky as an adjustable rate, but could still beat the interest rates of a fixed?
The turbulence in the markets over the past several years has left many annuity investors facing a similar dilemma: either settle for the relatively low rates offered by fixed contracts, or else endure the volatility of the debt and equity markets in a variable annuity.
However, unlike the world of mortgages, a third alternative now exists in the world of annuities. Equity-indexed annuities have been created to provide a happy medium between the ho-hum rates of fixed products and the uncertainty of variable contract returns.
Let’s first look at the basic properties of indexed annuities and then who would best benefit from them.
Equity-Indexed Annuities: The Basics
An equity-indexed annuity is a special type of fixed annuity, distinct enough to be accorded its own category. An indexed annuity provides you with exposure to one of the stock indices, such as the S&P 500, while guaranteeing the return of your principal investment. They provide you with the opportunity to capture a portion of the growth of the stock market while keeping one foot on dry land. These vehicles can effectively provide superior rates of return and still allow conservative investors to sleep peacefully at night.
Equity-indexed annuity contracts function much like their fixed counterparts in many respects. They have set maturities ranging from one to ten or fifteen years, a declining surrender charge schedule and tax-deferred growth. They also provide the same exemptions from probate and creditors.
But unlike regular fixed annuities, most equity-indexed contracts do not pay a set rate of interest. Instead, you’ll receive some portion of any growth posted by the benchmark stock index upon which the contract is based. The percentage of participation typically ranges anywhere from 60-90%, depending on various factors. For example, if you purchase an S&P 500 contract and this index rises by 20% over the seven-year term of the contract, you would realize perhaps three-quarters of that growth — without risking the principal.
Indexed Annuities and Their Short History
Indexed annuities are by far the newest form of annuity in existence. Keyport Life Insurance Company first introduced the KeyIndex product in 1998 (a few contracts of which I sold that year through Quick & Reilly). Now there are over 40 life insurance carriers that offer indexed annuity products.
The rates of participation and caps of these vehicles have generally improved overall since their inception, and billions of dollars are being poured into these products each year. Companies are also still creating new types of indexed annuities that provide various degrees of safe market participation with differing limitations.
In 2009, the SEC moved to make indexed annuities subject to their regulation as market securities, but this attempt was hotly contested by the life insurance industry and was eventually defeated in court.
Equity-Indexed Annuities at Work
Although they are externally fairly simple products as far as the investor is concerned, the inner workings of most indexed products are fairly complex.
Most contracts work in this manner: The premium paid by the investor is taken by the annuity carrier and divided into two parts:
- The lion’s share of the money is invested internally in a stable portfolio of securities that is guaranteed to grow back to the full amount of premium paid by the end of the contract term.
- The smaller portion is used to buy call options on the underlying stock index. These call options are a type of derivative, which will increase substantially in value when the underlying index rises, exponentially more than the amount of growth in the index. This profit is then used to pass along the growth to the investors.
Virtually all indexed contracts also have some sort of annual cap built into the contract on top of the participation rate, such as 10%. (Savvy investors can employ this strategy on their own and reap much higher returns than what they receive in prepackaged contracts due to these caps.)
Indexed Annuity Example
Harry invests $100,000 in a seven-year indexed annuity contract with a 70% participation rate and a 12% cap. In the first year, the index is based on the S&P 500 and rises a whopping 30% for the year. Harry’s total gain is limited to 12%, because the total gain from the participation rate exceeds this amount (70% of 30% = 21%).
Some contracts will keep the gains from one year and reset the caps each year, while others calculate gains on a cumulative basis for the term of the contract. State law requires that indexed contracts provide investors with at least a small amount of guaranteed interest as a form of consolation if the underlying benchmark index does not rise during the term.
How Are Indexed Annuities Taxed?
Equity-indexed annuity contracts are taxed in the same fashion as any other type of annuity. All money inside these vehicles grows tax-deferred until you take distributions. All distributions are reported and taxed as ordinary income, and any distribution taken before age 59 1/2 is assessed an additional 10% early withdrawal penalty by the IRS.
The amount of premium paid into these contracts is counted as a tax-free return of principal and is included with each periodic payment on a pro-rata basis according to the exclusion ratio (the ratio of principal contributed versus current contract value). If you purchase a $50,000 contract and it grows to $75,000, when you start taking periodic distributions, then 2/3 of each distribution will be counted as a return of principal.
Indexed annuities offer the same payout options as any other form of annuity, including:
- Joint Life. The same as straight life, except that the payments last until both beneficiaries are dead. Joint life payment plans are actuarially calculated based upon both life expectancies.
- Straight Life. You’ll receive a set periodic dollar payment until death. This form of payout offers the highest periodic payment, but the insurance carrier keeps the balance of the contract if you pass away before receiving back the full value of the contract, even if you receive less than the original premium.
- Life with Period Certain. You’ll receive a set periodic dollar payment until either your death or the end of a set period of time such as 20 years, whichever comes later. Period certain options protect beneficiaries from losing contract values to the insurance company because of an early death.
- Joint Life with Period Certain. You and your co-beneficiary will receive a set periodic payment that ends with the later of the death of both beneficiaries or the end of that certain period of time, such as 20 years.
- Lump Sum. You’ll simply withdraw the entire amount of the contract at once and either take the cash or move it into a different annuity plan.
- Systematic Withdrawal. You’ll periodically receive a specific dollar amount or percentage of contract value. This plan is often used for IRA mandatory minimum distributions in qualified contracts.
Should You Consider an Indexed Annuity?
Indexed annuities should be considered by any investor who seeks higher returns than those offered by traditional guaranteed instruments, but cannot afford to risk losing principal. However, you must be comfortable enough with absorbing the loss of any real gains if the underlying benchmark index upon which the contract is based does not perform well during the contract term. Older investors who still need some exposure to equities are prime candidates for these vehicles.
Proper Use of Indexed Annuities in Your Portfolio
There really are no set rules as to how these should be positioned inside a retirement portfolio. One possible example could be an investor with a $500,000 portfolio invested entirely in CDs and fixed annuities. This person could probably benefit from a longer-term contract with a higher cap and participation rate in order to provide a hedge against inflation.
Watch Out for Scams and Fraud
Although equity-indexed annuities are certainly appropriate products for many conservative investors, there are a number of unscrupulous insurance agents and financial advisors who aggressively market these vehicles to uneducated senior citizens and try to get them to liquidate all of their assets and place them inside these contracts.
Although these contracts do usually have some liquidity, they should generally not be the only type of vehicle used in a retirement portfolio. In many cases, these marketers pass themselves off as senior advisors in some official capacity, often by obtaining a flimsy financial credential that can be earned with a mere week or two of study. Then they invite a large group of senior citizens to a “power lunch,” where the audience gets a free meal in exchange for a high-powered sales pitch touting the limitless advantages of indexed products.
Many times the audience is strongly pressured to move their assets into these products on the spot, without taking the time to think it through. This practice has come under close scrutiny by both federal and state regulators and is also being closely monitored by the SEC. Beware of any invitation you receive offering a free lunch and the opportunity to “secure” your retirement for life.
Equity-indexed annuities can provide valuable market exposure for conservative investors, but they can also be easily misused. Those who can benefit from these products should be certain that they thoroughly understand all of the rules and restrictions in the contract. For further information on indexed annuities, consult your life insurance agent or trusted financial advisor.
Do you have experience with indexed annuities? Share your thoughts in the comments below.