Indexed Annuity
Candlefocus EditorWhen an investor buys an indexed annuity, a contract is created that stipulates the annuitant will receive back a predetermined percentage of any gain in the index (e.g., the S&P 500) over the contract period. The actual return of the annuity will depend on the degree to which the index increases, as well as any other contractual provisions that limit the return, such as participation rates and caps.
The index used by the annuity company to measure return must be clearly stated in the annuity contract. The indexes used can range from conservative ones such as the three month T-bill, to more volatile and higher return potential indexes such as the S&P 500 and the Dow Jones Industrial Average.
When considering any indexed annuity, it is important to look at the contract provisions carefully as these can limit the actual return of the annuity versus the return of the index. Participation rates and caps are two common provisions that affect the annuitant’s return.
Participation rate refers to the percentage of the index’s gain that is credited to the investor. This rate can be as low as 0% or as high as 100%. For example, if the index return was 10%, and the participation rate was declared at 70%, the investor’s credit would be 7%, or 70% of 10%.
The caps are imposed by the insurance provider and are linked to the index performance. They generally exist to limit the insurer’s exposure to the potential losses that can be incurred in the event of a significant downturn in the index. The caps can be set up in two ways: monthly or annual, and are expressed as a percentage above or below the index performance.
Overall, indexed annuities can be a good choice for annuitants looking to benefit from the gains in the financial markets without foreclosing the guaranty of a fixed annuity. To ensure that the annuitant receives a return that is commensurate with his or her risk profile and goals, it is important to ensure that all contractual provisions are carefully considered before signing any contract.