By Kelly Robinson, Spring 2016 Student Intern
Today we will be exploring the indexed annuity. The indexed annuity (AKA as the equity-indexed annuity or fixed-index annuity) is a combination of a fixed and variable annuity. An indexed annuity works by basing your returns on the gains of a stock market index, such as the S&P 500 (features of a variable annuity/security), while also guaranteeing a minimum return (features of a fixed annuity/insurance product). As with a fixed annuity, the indexed annuity is a contract between you and an insurance company, and is therefore regulated by the state insurance commissioner. Some misleading agents, as well as the general complexity of these products sparked FINRA to issue an Investor Alert about indexed annuities. It provides a wonderful walkthrough of how to analyze various indexed annuities and what questions to ask your agent before investing.
Indexed annuities can be very complex and come with a wide variety of options that can affect your return. One issue is trying to understand the method used to calculate the gain in the index to which the annuity is linked. This formula can be based on a number of factors such as participation rates, interest rate caps, and margin fees; however, this list is not exhaustive. For a more in-depth review of how each of these is calculated, check out the SEC’s Investor Bulletin on Indexed Annuities. Another issue is trying to compare indexed annuities to one another. The variety of methods used to calculate your gains makes it difficult to be accurate in your comparisons.
While often pitched as “the best of both worlds,” this concept is a little misleading. With regard to the guaranteed minimum return, some might assume that this means you are guaranteed to make some money, or at least not lose any. Unfortunately, this is an incorrect assumption. Instead, the typical guaranteed rate is set at 87.5% of the premium paid, at 1-3% interest. That means if no interest is gained (your index declines), you can lose money on your investment. As mentioned above, it can be difficult to estimate your return amongst the varying indexed annuities, but making it harder is that the insurance company may retain the right to change these rates annually, so it’s very important to read over your contract to understand what to expect (to the extent that you can).