Indexed Annuities
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Annuities are insurance contracts that buyers pay into today to receive a benefit in the future. But how much will you get, and when? It all depends.
An index annuity is an annuity whose rate of return is based on a stock market index, such as the S&P 500. Unlike most variable annuities, an indexed annuity sets limits on your potential gains and losses. These annuity contracts are less risky than investing directly in the market but have less upside.
How Does an Index Annuity Work?
Like most annuities, index annuities can provide you with a steady income in retirement. Before you start receiving any income, though, you must first agree to and fund a contract. Your contract will spell out how you will fund your annuity—all at once with a lump sum or steady payments over time—and when you can begin to withdraw. The annuity company will invest your money using the index you select. The exact indexes available depend on the annuity company, but common indexes include the S&P 500, the Nasdaq 100, the Russell 2000, and the Euro Stoxx 50. You can put all your money in one index or split it across several.
Equity-indexed annuities may be safer than investing directly in index funds because the annuity company protects you against losses. That, of course, comes with the tradeoff that you won’t earn the same high returns that an index fund outside of an annuity might have. Index annuities also benefit from tax-advantaged status, similar to 401(k)s or IRAs. This means your investment returns will grow tax-deferred until you withdraw them.
Index Annuity Returns
The amount your indexed annuity earns is based on the underlying index. Let’s say you buy an S&P 500 inde annuity. When that market goes up, you make more money, but when the market goes down, you earn less and may even lose money. The long-term annual average rate of return for the S&P 500 is about 10%. But you won’t see quite that return on your investment.
Minimum Guaranteed Return
The annuity company could guarantee a baseline minimum return each year, even if the underlying index loses money.
For example, it might pay 1% even if your target index has a negative yearly return.
- Loss floor. Your contract may also include a loss floor, which is the most you could lose in a market downturn. A contract might set your floor at 10%, which means 10% would be the most of your deposit you could lose from market losses.
- Adjusted value. Your index annuity may lock in your gains periodically. In other words, if your balance goes up, the annuity company could guarantee that it would not fall below that new adjusted value, even if the index loses money.
- Return caps. Conversely, the annuity company might set the maximum possible return per year. For example, the most you could earn might be 6% per year, even if the underlying index earns more.
- Participation rate. The participation rate describes the percentage of index returns that the annuity will pay. If your participation rate were 70%, you would only receive 70% of the index gains. If the index went up 10%, you’d receive 7% (10% x 70%).
- Spread/margin/asset fees. The annuity company may deduct a fee from the index return. If its fee were 4% and the index returned 10%, your gain would be 6% (10% minus 4%).
Your actual index annuity could contain any combination of these caps and fees. Accounting for various caps and participation rates, annuity market research company Cannex estimated in 2018 that over seven years, an index annuity might yield 3.26% on average annually. That said, rates of returns will significantly vary based on the stipulations of your annuity contract.