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Indexed annuities, also known as equity indexed annuities, are contracts between an individual and an insurance company. These types of annuities earn their return based upon an external market index such as the S&P 500 or the DJIA (Dow Jones Industrial Average).
Similar to other types of annuities, an indexed annuity will provide tax-deferred growth of the funds that are inside of the account. This means that there is no tax due on the gain of the funds until the time they are withdrawn.
In addition, an indexed annuity can also provide a guaranteed stream of income to its holder at retirement, as well as certain other riders and income payment options that essentially allow its owner to “customize” the annuity to more closely fit their specific needs.
There are several ways in which an indexed annuity differs from other types of annuities. One of the most distinguishing of these is the fact that an indexed annuity holder can lock in market gains while at the same time being protected from market downturns and keep their principal safe from loss.
In other words, even though there is the potential for market linked growth, there is no exposure to market risk. Therefore, these annuities can essentially be thought of as offering “the best of both worlds”.
The annual point-to-point method of crediting interest tracks changes in the underlying market index from one contract anniversary of the annuity to the next. It will then credit the interest based on that annual change.
With the monthly average method, the individual monthly values of the underlying index are totaled, after which the total will be divided by 12, in order to determine the monthly average.
The high water mark method looks at the values of the index throughout various times during the annuity contract. It then takes the highest values and compares them to the underlying index level at the beginning of the term.
A cap rate determines the maximum amount of interest that the issuing insurer will pay out on the indexed annuity. So for example, if an underlying index returns 10% in a given period, but the annuity has a cap rate of 7%, the annuity holder will receive a maximum of 7% interest for that period.
Participation rate is the amount that the issuing insurer will give the annuity holder in the underlying market index. As an example, if the participation rate is 80%, then the annuity holder will be allowed to obtain 80% of that period’s market gains. Therefore, if the underling index rose by 10% in a given period and the participation rate is 80%, the annuity holder would receive 8% (as 80% of 10% is 8).
There are many benefits to owning an equity indexed annuity. These can include:
While an index annuity may not be the ideal option for everyone, there are some individuals who may want to consider this type of annuity as a part of their overall financial planning for retirement. For example, an index annuity may be a good option for those who:
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