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Indexed Annuities | Information on Fixed Index Annuity (FIA).

All about indexed annuities

One of the most difficult decisions investors have to make it whether to play it safe and earn a smaller return or put their money at risk for the hope of a larger return. To help people saving for retirement, insurance companies several years ago created an alternative that provides the best of both worlds. They’re called Indexed annuities.

How an indexed annuity works
A indexed annuity (sometimes referred to as a fixed indexed annuity or FIA) is a contract with an insurance company. You make a single purchase payment or a series of payments to the company. The annuity can provide a lifetime stream of income or payments over a contractually defined term.

What sets indexed annuities apart from other types of annuities is the method of crediting interest. They earn interest based on the movement of a market index, giving them the ability to grow higher in value than fixed annuities that charge a flat rate of interest. However, you are not actually invested in the market or in any index. The insurance company simply uses the index as a measuring stick for how much to credit to your contract.

Indexed annuities also have a provision whereby the contract cannot lose value based on how the corresponding index performs. If the index loses 5 percent, 15 percent or even 75 percent in a given period, the annuity’s account value remains steady. Zero interest is the worst your contract can return in a given period. This makes it a safer alternative to a variable annuity.

Indexed annuities use a variety of market indices. Some contract will even offer you choices on what indices you want your contract to be based upon. The most common index used as a benchmark is the Standard & Poor’s 500 (S&P 500), which is a widely used index to measure the U.S. stock market. Other options include the Russell 2000, the Wilshire 5000 and a number of international market indices.

Fixed annuities charge annual fees that include a mortality and risk expense charge and an administrative fee. There will also be fees for any optional benefits (see below).

Crediting strategies
Insurers offer several formulas for crediting interest, often called strategies. Some use monthly index movements while others calculate an average movement over a given period. The most common strategy is a one-year point-to-point strategy. This strategy measures the one-year growth of an index and applies that percentage to the annuity’s account value. If the index declined in value during that one-year period, the annuity’s account value will not lose any principal.

Caps and spreads
Because indexed annuities do not lose principal, there has to be a limit on their upside. As an indexed annuity holder, you’re essentially trading unlimited interest rate growth for the protection against negative returns.

Insurers have two methods of limiting an indexed annuity’s upside: caps and spreads.

A cap is a ceiling on interest rate growth. A typical cap might be 8 percent. That means your annuity’s account value can not increase more than 8 percent in any one period, regardless of how much the benchmark index increases. If the index increases 5 percent, your account value will increase 5 percent. If the index climbs 12 percent, the account value will be limited to 8 percent.

A spread, on the other hand, acts more like a floor. If your annuity has a 5 percent spread, your account value will increase by whatever percentage above 5 percent the corresponding index goes up. If the index increases 7 percent, your account value will grow 2 percent (7 – 5). If the index climbs 15 percent, your account value will earn 10 percent. But if the index only increases 3 percent, your account value will earn nothing for that period.

Whether it’s more advantageous to be subject to a cap or spread depends on how the index performs over time. If the index has several large increases, then a spread will likely provide a better return since there is no upside limit. If the index has more moderate increases, then an annuity with a cap rate will likely do better.

Why zero is your hero
Let’s say you invest $100,000 in a regular investment that immediately loses 10 percent, taking the value down to $90,000. The investment will then have to gain 10 percent just to get you back to even.

Using that same scenario with an indexed annuity, the 10 percent loss does not impact your annuity’s account value: You still have $100,000. The next year when it increases 10 percent, instead of that 10 percent being added to a $90,000 balance, it’s being added to a $100,000 balance. Even if the annuity had a 7 percent cap, you would still have $107,000 in the annuity account value vs only $100,000 in the regular investment.

How an indexed annuity is taxed
Money deposited in an indexed annuity grows tax-deferred until you take distributions. Because of this, you must wait until age 59 1/2 to withdraw funds from the annuity. Doing so prior to age 59 1/2 will result in a tax penalty.

You will not pay tax on the portion of your payments that is considered a return of your original premium. The taxable portion is what your annuity pays above and beyond what you put into it. For example, if the value of your annuity doubles what you deposited, then half of your income withdrawals will be taxed as regular income. The other half will be considered a return of your principal.

If you transferred money from a 401(k) or IRA, your annuity payments will be taxed as regular income, since you would not have paid taxes on the gains in those investments prior to depositing them in the annuity.

Features and benefits
Indexed annuities have many of the same features and benefits as regular fixed annuities. They typically have a surrender period during which you will pay a penalty if you withdraw some or all of the annuity’s account value. At the same time, they also typically offer free withdrawal percentages during this period.

Insurance companies also offer many of the same optional features to these products to make them more flexible, including income riders, premium bonuses, return of premium provisions, and increased income for confinement or illness.