Index Annuities

How Do Index Annuities Work

Index annuities are known as hybrid annuities. As a relatively new type of investment product introduced by insurance companies in the mid-1990s, they contain elements of both fixed and variable annuities. Like fixed annuities, index annuities guarantee that an investor’s account will not fall below his or her initial investment. Like variable annuities they provide for substantial growth potential based on an increase in the equity markets.

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Equity Indexed Annuities

The return credited to index annuities is tied to a market index. While it can be tied to an index that tracks small or medium cap stocks, the broader S&P 500 is the index most commonly used. For this reason, index annuities are often referred to as equity-indexed annuities. When purchased as deferred annuities as part of a retirement account, index annuities have two phases: The accumulation phase and the distribution phase.

The Accumulation Phase

The accumulation phase is the period during which money is accumulated in the account. This can take the form of one large, lump-sum payment or money can be contributed in a series of payments over time.

The Distribution Phase

Once an index annuity is annuitized the payouts begin. The annuitant can choose to take distributions as monthly, quarterly or annual payouts. The amount of the payout and how many years they last depend on the tax status of the annuity. If the annuity was purchased as part of a retirement plan with tax-qualified money, the payouts will be in an amount determined by the Internal Revenue Service based on the annuitant’s life expectancy.

If the annuity was purchased with after-tax dollars, the payout amounts will be determined either by the amount the annuitant chooses to receive in each payment or by the number of months or years he or she chooses to receive payments.

When index annuities are purchased as immediate annuities, the payouts begin immediately. Unlike a deferred index annuity, the time between the accumulation and distribution phases is at most 12 months. Immediate annuities are purchased with one payment, and can be funded with money from a savings account, inheritance or even with the distributions from a qualified annuity.

How is Interest Credited to Index Annuities

One of the most significant aspects of purchasing an index annuity is choosing the method by which interest and earnings are credited to the account. At the time of annuitization, index annuities owners can choose among three methods of crediting: The high-water mark method, the point-to-point method and the annual rest method.

High-Water Mark Method

Index annuities that use the high-water method to calculate the amount of earnings to credit the account mark several points during a 12-month period and use the highest mark to compare one year to the next.

Point-to-Point Method

The point-to-point method uses two points during the annual term of the annuity. The most common points used are the beginning of the term and the end of the term. If the index is higher at the beginning of the term than it was at the end, the difference is used to determine earnings.

Annual Reset Method

The annual reset method calculates the change in the percentage of the index from the start of the initial contract year to the end of that year, and then the end of each following contract year.

However, insurance companies that sell index annuities may not pay interest on the entire amount of the principal within the account. The portion of the account on which interest and earnings are paid is known as the “participation rate”.

The participation rate is the amount of the principal that “participates” in the earnings. In other words, the entire balance of the account is not used to calculate earnings. For example, if the participation rate is 85% and the increase in the S&P 500 is 2%, the gain credited would be 1.7%. The amount of the return is figured by multiplying the participation rate (85%) by the increase in the market index (2%). Further, some insurance companies will put a cap on the maximum percentage that can be credited to an account.

What Returns Can Be Expected with Index Annuities

The returns on index annuities depend on the participation rate, administration fees and the method of calculating earnings. In addition, some insurance companies will place a cap on the maximum amount that can be earned on an index annuity. If, for instance, the cap is 5%, this will be the maximum amount that will be credited, even if the index has increased by 6%.

Index annuities, like all annuities, grow tax-deferred even if they are not part of a retirement account. When money is not removed from the account to pay taxes, more money is available to compound over time. This results in an ever larger account to which earnings can be credited. And, most life insurance companies that sell index annuities will guarantee that the value of the index annuity will not drop below the value of the total premiums paid, regardless of market performance. During times of extreme market turbulence, especially during market downturns, this can be a significant benefit to owning index annuities.

Who Are Index Annuities Designed For

Index annuities are often recommended as alternatives to index mutual funds. While index annuities may not pay the same rate of return in the same year as an index mutual fund or ETF (exchange traded fund), an investor’s money is usually guaranteed against lost of principal. And while the fees for administering index annuities may be higher than those of mutual funds or ETFs, the guarantee of principal and the tax-deferred status may provide for greater gains over time.

Index annuities can play an important part in an individual retirement account or as part of a personal savings plan. Because index annuities grow tax-deferred, regardless of whether or not they are purchased with pre-tax dollars, they can be especially useful for younger investors who have contributed the maximum allowed by law to a retirement account. Index annuities can also be well suited for older investors who wish to guarantee a lifetime stream of income.

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