Indexed annuities are an investment option that runs through an insurance company. The amount of interest that is paid on the investment is dependent upon an assigned index, which is usually the S&P 500 in the United States. On a basic agreement, individuals would invest money into the annuity and then receive a return based on the performance of the index. If the index rises by 7% over 12 months, then the interest on the investment would be 7%.
The advantage of indexed annuities is that it is a guaranteed contract with the insurance company. In return, investors receive a level of protection against markets that are moving in downward trends. Many policies market themselves as providing $0 loss in a down market, which means the risks of losing money are reduced for investors.
The disadvantage of indexed annuities is that the strength of the policy is dependent upon the insurance company’s ability to honor the contract. An insurance company that is weak financially may not be able to honor their contract and that could create an unexpected loss that could encompass the entire investment.
Here are some additional pros and cons of indexed annuities to consider before making an investment.
List of the Pros of Indexed Annuities
1. Money grows on a tax-deferred basis.
The investment into an indexed annuity is similar to what investors of a Roth IRA in the United States get to experience. The money invested into the policy grows on a tax-deferred basis. That means any gains experienced do not experience taxation. In some instances, if post-tax dollars are used for the investment, there may be no taxation involved at all for some individuals unless they withdraw from the annuity early.
2. New guarantees can be locked in over time.
Markets go up and they go down. That means there are some years when a base contract value can be extremely beneficial and other years where it will not be. Look for indexed annuities that allow for a new base value to be locked-in when the index performs above expectations so a new guarantee can be implemented on the policy.
3. There is a growth guarantee.
For most indexed annuities, there is more than just a zero-loss benefit in the investment. Many policies guarantee that the initial investment will grow by a specific minimum amount. That means investors are guaranteed to receive a specific return at the end of their surrender period. That guarantee is the minimum. There is also the potential for the indexed annuity to grow beyond those minimum expectations.
4. Index gains are permanently locked.
Even when the index option expires on this type of annuity, the gains which are experienced become permanently locked. That means the returns offered by many indexed annuities can outperform traditional low-risk growth options, such as a Certificate of Deposit. At the same time, the principal of the initial investment is still protected as well.
5. They can provide future income needs.
An indexed annuity provides an efficient way to create a contracted plan for future income needs. Riders can be included to provide benefits that may include confinement-care or long-term care coverage, which can provide a level of financial protection for an individual’s estate.
List of the Cons of Indexed Annuities
1. The insurance company often controls your upside.
Insurance companies can limit participation within the annuity. They can put caps onto the annuity to limit how much they must pay out. Many indexed annuities are poorly constructed and do not have beneficial caps or participation rates for the individual investor. Some caps can be as low as 1.5% and create artificially low participation rates to keep the upside as low as possible.
2. There can be long surrender periods involved.
Some insurance companies offer very long surrender periods with their indexed annuities. There are some that may be as long as 15 years. A more realistic surrender period for an investor would be 5-7 years at most. There should also be provisions within the policy that allow money to be taken out during the surrender period without penalty as well. Otherwise, the indexed annuity is designed to make the insurance company more money than you.
3. It may have confusing or complex crediting methods.
Some indexed annuities use a proprietary index that can be difficult, if not impossible, to track independently. Others use obscure indexes or incorporate a complex crediting method that can make it difficult to understand the full potential of the annuity. When shopping around for an indexed annuity, it is important to look for options that are easy to monitor and understand so you can always know what is happening with your policy.
4. Indexed annuities are not classified as securities.
Because indexed annuities are not securities, the sales pitch can sometimes be unregulated. That means they are regulated at the state-level in the U.S. and laws regarding them can vary from state-to-state. Some may not require companies to disclose limits like caps or participation rates until the contract is extended to the investor. One common way to limit gains is to place a call option on an index to create limited gains on contract anniversaries.
5. Many contracts allow for the issuer to change the rules at their discretion.
The average contract for an indexed annuity allows for the issuing carrier to change the rules of the contract at their discretion. This allows the carrier to change how gains are credited based on the current market conditions. Read through the contract very carefully before signing it to avoid this common issue.
6. Attached income riders are common with indexed annuities.
Many indexed annuities are sold with an income ride that is used for a lifetime income stream. This can be a beneficial financial product for some individuals, especially if the goal of the investor is to create target-date income. For many, however, this rider is perceived as a real yield when that is simply not the case.
7. There can be high fees and commissions involved with indexed annuities.
It is important to look at the management and administration requirements of the indexed annuity before investing. Higher requirement levels provide higher administrative fees that must be paid. Internal fees can be quite high and some commissions may be around 10% on the initial purchase.
These indexed annuities pros and cons are generalized. Every financial situation is a little different. You may not receive stock market returns with this type of product, but it can also be used for future income needs when managed correctly. Shop around for the best financial product to meet your expectations for the best results.