Understanding Indexed Annuities: A Step-by-Step Approach
When it comes to the investment approach, there has been a noticeable shift in individual preferences.
Individuals planning their income after retirement are increasingly looking for options that offer more protection than growth. It is, hence, not surprising to see index annuities that offer guaranteed returns and downside protection gaining more traction.
This post offers an insight into indexed annuities, how they work, and whether it would be a good choice to incorporate them into your retirement plan.
Introducing indexed annuities
Indexed annuities are a financial contract between you and an insurance company. They offer returns that are tied to a certain market index performance, the S&P 500, for instance.
There are two main phases of an indexed annuity- an accumulation phase and an annuity phase. Here is a brief account of each.
Accumulation phase
In the accumulation phase, you are required to invest funds with the insurance company. These submitted funds may be allocated to various indexed investment options. In simpler terms, the insurer takes your money and invests it in an index fund that tracks the selected market index, like the S&P 500. The insurance company will then credit your account based on the performance of those particular investment options.
Annuity phase
Next comes the payout or annuity phase! In this phase, the insurer begins to make regular payments to you. You can also choose to receive a one-time lump sum amount. This depends on the nature of your contract.
It is important to note that all indexed annuities are not necessarily regulated by the SEC (Securities & Exchange Commission. Only the ones classified as securities may be subjected to SEC regulation. These annuities come with investment risks. So, if you are investing in an SEC-regulated indexed annuity, you must keep this in mind.
At the same time, indexed annuities are also regulated by state insurance commissions. Annuities not regulated by the SC usually include minimum guarantees to protect investors from losses.
Earning with an indexed annuity
An indexed annuity that comes with a minimum guarantee may be a good option for individuals who want a safer investment with a chance to earn even more. Simply put, investing in an indexed annuity means taking the sting out of inflation! Many insurers offer you a minimum yield even in case of a market downturn. This way, you can expect to earn, albeit a limited return, regardless of how the market index performs.
How much you earn would usually depend on aspects like the index used, the formula used for calculating returns, and the guaranteed minimum.
There are various important factors that need to be considered. For instance, the crediting method is one consideration that refers to how the change in the index is to be measured. Then there is the participation rate or the percentage of index gains you get and the spread or margin which is the amount subtracted from index gains before they are credited to you.
Another factor is the performance rate, i.e., how much you will get based on index returns. Finally, there is the set-up rate or floor which is the minimum return you get in case the index does not perform well.
It is important to note that these factors will vary between different insurers and from one contract to another. That said, it is important to read the disclosure document carefully before you make an investment decision.
Features of an indexed annuity
Tax-deferred earnings
Indexed annuities offer tax-deferred earnings! This implies that you do not pay taxes when your investment grows until you withdraw the money. This can help your money grow faster. However, when you withdraw, you will be required to pay taxes on your earnings. Also, if you opt to withdraw earlier than the surrender period, you will have to pay a penalty.
Death benefits
When you pass, your beneficiary will receive the death benefit. It is generally the amount you originally invested or even more. In some cases, insurers offer contracts with enhanced death benefits for an added fee.
Living benefits
Many index annuities also offer living benefits. This can provide a guaranteed income during retirement. These benefits may help protect your retirement income from any possible market downturns. However, it is pertinent to note that they come at an extra cost. There may also be rules regarding when you can use them.
That said, it is important to read the contract carefully so that you can understand the relevant specific terms and associated costs of each option before you invest in an indexed annuity.
Final note
Like its conventional counterpart, the fixed annuity, indexed annuities offer various benefits.
One such benefit is that it helps protect your principal while limiting your exposure to market downturns by guaranteeing a return that is usually between 1 and 3%. Hence it would not be wrong to say that if you want to take the factor of uncertainty out of your retirement income, an index annuity may perhaps be one of the most ideal options for you.