What is an index annuity?
An index annuity is a fixed annuity offered by an insurance company. The index annuity earns a minimum rate of interest and offers the potential for excess interest based on the performance of an index.
There are two major types of annuities in the world — fixed and variable. Variable annuities operate a lot like mutual funds in that most of the investment return (and all of the risk) is passed to the investor. Fixed rate annuities operate more like an account at a bank paying a stated rate of interest (although annuities are not bank instruments). Fixed index annuities pay a minimum rate and the potential for more interest depending on the performance of an independent equity or bond index.
Since interest is based on an index, isn’t this like a variable annuity?
No. If a variable annuity account goes down, you could lose principal. Index annuity principal is protected from market risk – you can’t lose principal if the index declines. Variable annuity gains are typically not locked in. Once index-linked interest is credited in an index annuity it cannot be lost, even if the index subsequently declines. And, variable annuities include reinvested dividends, neither the index nor index annuities reflect reinvested dividends.
So do I get all of the index gains and none of the losses?
No. It costs the insurance company to provide this protection against loss. This typically means that you won’t fully participate in all of the gains when the market increases, but you also won’t lose any principal in a falling market.
What kind of interest will I earn?
Index annuities are designed to provide a return competitive with other savings instruments. Because interest is linked to movements of an index there could be periods when the index annuity credits double digit interest rates and years when zero is credited. But index annuities were created with the intention of providing the realistic potential for higher interest rates than other instruments that protect principal from market risk.
How could I earn zero?
The primary goal of the minimum guarantee is to protect the principal from market risk. So if the market drops, the worse thing an index annuity owner would say is “Gee, I didn’t lose any principal”. Many companies minimize the minimum guarantee so that if the market stayed down for years, the owner would only get back their money and a few dollars of interest. By minimizing the minimum, and only crediting the minimum guarantee at the end of the term, companies can let index annuities participate in more of the index performance.
There are index annuities that credit at least a minimum interest rate every year, others that offer the thinnest possible minimum return to maximize participation in the index, and still others in between. You should select the guarantee you are most comfortable with.
Do index annuities have fees?
Not in the same way that a variable annuity or mutual fund does, but more like the way a bank does it. Index annuities have penalties for early withdrawal if you surrender the annuity early. You need to match the period with your goals, keeping in mind that all annuities are designed to be long term savings instruments.
The cost of providing the minimum guarantee and the interest-linked interest means that the index annuity probably won’t fully participate in any index increases. So, if the index goes up you’ll probably get some to most, but not all, of the upside. This doesn’t mean that the insurance company gets the other part of the increase. After protecting the minimum guarantee and covering expenses, any remaining money is used to provide the index-linked interest. Sometimes there could be enough remaining money so that the index annuity fully participates in the market, but today the net effective participation of index annuities — the amount of any index gain that would be credited to the index annuity — is less. Of course, if the index is lower at the end of the period you won’t participate in any losses.
What returns have index annuities actually credited?
The highest index annuity interest rate credited for one year was over 40%. In 2001 and 2002 the stock market was down and most index annuities credited 0%.
Index annuities have been around since 1995. During this period we’ve seen the strongest bull market in ages, with five years of high double-digit stock market gains, and the worst bear market in a generation; hardly a “normal” period. Index annuities are designed to provide a return somewhere between stock market vehicles and savings instruments and they’ve been performing as intended.
Are all index annuities the same?
No. Index annuities have differing penalties for early withdrawal, may offer different indices, and one index annuity probably calculates index gain, and credits interest, a little differently from another.
Some index annuities credit interest each year, some wait until the end of a longer period, some average the index values, others set a cap or maximum on the interest that may be paid, and some guarantee all of the fees or moving parts won’t change, while others have the flexibility to adjust. What all of this means is one company could offer 100% participation in their way of calculating interest, and still credit less interest than another company that participates in 60% of a different method. Or, a company with a 3% “asset fee” could pay more than another company quoting a 0% fee.
Do insurance companies intentionally make index annuities complicated?
Yes.
Which type of annuity is best?
I can’t give you a straight answer because different types of annuities may work better in different kinds of markets.
For instance: If a market is generally rising over time, index annuities with what we call a “term end point” method should do better. These are annuities that don’t lock in interest gains until the very end of the term, and they could credit more interest than other methods. But,
If the stock market of the future posts modest gains each year, then the best method may be one that places a cap on the maximum interest credited. The cap method allows you to get “more of a little” instead of “less of more” and works better during periods of general market stability. However,
If the market is very volatile, the best performing index annuity might average index values. Averaging index values means you always wind up at the middle. So with averaging, you won’t get the highest possible return, but you are also guaranteed not to get the lowest.
In addition, there are index annuities that use still other interest crediting methods, or a combination of methods, to calculate the return.
If different index annuities perform differently, how do I pick one?
If your crystal ball says the market will be heading up, and you can wait until the end of the multiple year period before you see any index-linked interest credited to the annuity, then the “term end point” methods may well provide the highest returns.
If you need to see index derived interest credited to the annuity each year, then you should pick an insurance company you trust and an index annuity with a term and structure that matches your needs, regardless of the crediting method.
I’ve done enough analysis to see that all of these other crediting methods should produce about the same results if you wait long enough — unless you know for certain how the stock market will move in the future — so the key is picking an index annuity carrier that will treat you well down the road. Every index annuity company utilizes the services of agent. You need to find an agent you can trust to help you in picking the right index annuity for your situation.
Are index annuities safe?
I think so. Both principal and credited interest are protected from index declines, so the worst thing that could happen is the stock market drops for years and you still get back your principal plus a little interest. The index annuity is as safe as the insurance company issuing the annuity. No index annuity owner has ever lost money because the insurance company failed.
Am I worried about the insurance company going under? No. States and independent rating firms on a regular basis examine the financial books of insurance companies, and they look to make sure there’s enough money to cover everything, which is why you very rarely hear of an insurance company going bust. What if a company does go belly up? An annuity contract is an asset of the insurer, and in the past another insurer has bought the annuity contracts of the troubled company and life goes on. And every state has a guarantee fund to dip into and protect annuity contract owners (up to a certain limit) if a company tanks. It is possible to lose money if an insurance company fails, but based on history it is not very likely. The way I look at it is my car is insured, my house is insured, and my life is insured. I’m not losing any sleep over these insurance companies, why should the annuity carrier be any different.
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Who buys an index annuity?
People purchase an index annuity because they want the potential to possibly earn more than they might make from another savings vehicle. If you have sufficient time to recover from potential losses (and the stomach for it) direct stock market investments should give you a higher return than index annuities. However, if your timeframe is too short to recover from a possible bad market, or you simply don’t like the idea of possibly losing principal in the market, index annuities are used as an alternative savings vehicle to bank instruments, fixed rate annuities, bonds and bond mutual funds.
