Indexed Annuities

Why Consider a Fixed Annuity?

A fixed annuity is one of the most common types of annuities. In general, they pay a fixed interest rate. Fixed annuities have pros and cons associated with each of them, and should be carefully considered before purchasing.

As the name implies, the interest rates associated with fixed annuities are fixed. They are usually set in advance, so the consumer knows what to expect from them before purchase. Some fixed annuities offer longer term interest rate guarantees, ranging from 1-10 years usually. Another type of fixed annuity may change its interest rate on an annual basis. Most all fixed annuities have a minimum interest rate guarantee. Before purchasing a fixed annuity, make sure to understand what the minimum interest rate guarantees are so you fully understand the contract.

In addition to the interest rate, it is also important to consider surrender periods and charges. One should plan on holding the annuity until the surrender periods have been satisfied, thus making the annuity liquid without any penalties. In the event that an annuity owner needs access to their money before the surrender charge period is up, they may incur a surrender penalty. Understanding these penalties will be an important consideration before purchasing a fixed annuity. Many fixed annuities will allow for penalty-free withdrawals. This is often in the amount of 5 or 10% of the contract’s value. Carefully consider your liquidity needs before purchasing a fixed Annuity.

Who might consider a fixed annuity?

• An individual who wants a fixed, guaranteed rate of return.

• An individual who does not want volatility in their investment.

• An individual who can work within the constraints of the annuity contract.

Annuities are best suited for long term investors.  Any withdrawal prior to age 59 ½ is subject to a 10% tax penalty as well as regular income tax.  Annuities often also have a surrender schedule, meaning that withdrawals may be subject to a penalty by the insurance company if not left in for a predetermined amount of time.  Any guarantees on principal invested is based upon the claims paying ability of the underlying insurance company.

What is an Equity Indexed Annuity

An equity-indexed annuity is an annuity that earns interest that is linked to a stock or other equity index. One of the most commonly used indices is the Standard & Poor's 500 Composite Stock Price Index (the S&P 500).

HOW ARE THEY DIFFERENT FROM OTHER FIXED ANNUITIES?

An equity-indexed annuity is different from other fixed annuities because of the way it credits interest to your annuity's value. Most fixed annuities only credit interest calculated at a rate set in the contract. Equity-indexed annuities credit interest using a formula based on changes in the index to which the annuity is linked. The formula decides how the additional interest, if any, is calculated and credited. How much additional interest you get and when you get it depends on the features of your particular annuity.

Your equity-indexed annuity, like other fixed annuities, also promises to pay a minimum interest rate. The rate that will be applied will not be less than this minimum guaranteed rate even if the index-linked interest rate is lower. The value of your annuity also will not drop below a guaranteed minimum. For example, many single premium annuity contracts guarantee the minimum value will never be less than 90 percent (100 percent in some contracts) of the premium paid, plus at least 3% in annual interest (less any partial withdrawals). The insurance company will adjust the value of the annuity at the end of each term to reflect any index increases.

WHAT ARE SOME OF THE CONTRACT FEATURES?

Two features that have the greatest effect on the amount of additional interest that may be credited to an equity-indexed annuity are the indexing method and the participation rate. It is important to understand the features and how they work together.

Indexing Method
The indexing method means the approach used to measure the amount of change, if any, in the index. Some of the most common indexing methods include annual reset (ratcheting), high-water mark and point-to-point.

Participation Rate
The participation rate decides how much of the increase in the index will be used to calculate index-linked interest. For example, if the calculated change in the index is 9% and the participation rate is 70%, the index-linked interest rate for your annuity will be 6.3% (9% x 70% = 6.3%). A company may set a different participation rate for newly issued annuities as often as each day. Therefore, the initial participation rate in your annuity will depend on when it is issued by the company. The company usually guarantees the participation rate for a specific period (from one year to the entire term). When that period is over, the company sets a new participation rate for the next period. Some annuities guarantee that the participation rate will never be set lower than a specified minimum or higher than a specified maximum.

Cap Rate or Cap
Some annuities may put an upper limit, or cap, on the index-linked interest rate. This is the maximum rate of interest the annuity will earn. In the example given above, if the contract has a 6% cap rate, 6%, and not 6.3%, would be credited. Not all annuities have a cap rate.

Floor on Equity Index-Linked Interest
The floor is the minimum index-linked interest rate you will earn. The most common floor is 0%. A 0% floor assures that even if the index decreases in value, the index-linked interest that you earn will be zero and not negative.

HOW DO I KNOW WHICH EQUITY-INDEXED ANNUITY IS BEST FOR ME?

As with any other insurance product, you must carefully consider your own personal situation and how you feel about the choices available. No single annuity design may have all the features you want. It is important to understand the features and trade-offs available so you can choose the annuity that is right for you. Keep in mind that it may be misleading to compare one annuity to another unless you compare all the other features of each annuity. You must decide for yourself what combination of features makes the most sense for you. Also, remember that it is not possible to predict the future market behavior of an index.

Annuities are best suited for long term investors.  Any withdrawal prior to age 59 ½ is subject to a 10% tax penalty as well as regular income tax.  Annuities often also have a surrender schedule, meaning that withdrawals may be subject to a penalty by the insurance company if not left in for a predetermined amount of time.  Any guarantees on principal invested is based upon the claims paying ability of the underlying insurance company.

Top Fixed Annuity Companies by Ratings

Are you the type of person who thinks about the future or stays in the present day? Are you beginning to think more and more about retirement? If you are in retirement, and considering the purchase of an annuity, it is important to consider some “what ifs.” One of these “what ifs” is the strength of an insurance company. There are hundreds of insurance companies in the marketplace. Evaluating them carefully before doing business with them is a prudent thing to do.

When an insurance company is declared insolvent, thousands of policyholders suddenly find themselves with some challenges. In addition to the potential loss of their premium dollars, they may be forced to purchase replacement coverage from other carriers, sometimes at higher rates. If savings are held by the insurer or scheduled pay outs are in process at the time of failure, those funds can be frozen and the guaranteed payments called into question.

That's why it is so important to periodically monitor the financial condition of each company with whom you have an insurance relationship.

There are a number of different rating agencies. Some of them are Weiss, Standard & Poor’s, A.M. Best, Moody’s, and Fitch.

In today’s challenging economic environment, it might be wise for you to ask for the financial strength ratings of a company you are considering purchasing an annuity with. Carefully evaluate their strength. It may be wise to focus on companies that receive A ratings. While an “A” rating is not a guarantee that the company won’t have financial troubles, it is likely a good indicator of the overall strength of the company.

Another important thing to know about insurance companies and purchasing an annuity is the State Guaranty Association. Each state has different rules and guidelines. It would be worth doing some homework on your individual state’s Guaranty Association before purchasing an annuity.

As we’ve stressed on this website, there is a lot that goes into purchasing an annuity. Making sure the rates and terms of the annuity contract is important, in addition to carefully evaluating the insurance company you are considering purchasing the annuity from.

Annuities are best suited for long term investors.  Any withdrawal prior to age 59 ½ is subject to a 10% tax penalty as well as regular income tax.  Annuities often also have a surrender schedule, meaning that withdrawals may be subject to a penalty by the insurance company if not left in for a predetermined amount of time.  Any guarantees on principal invested is based upon the claims paying ability of the underlying insurance company.

The Risk Factors of Fixed Annuities

With the exception perhaps of the Treasury bonds, no investment is risk-free. Among fixed annuities, sometimes they may offer a little higher than average return as compared to other fixed investments. After all, these bonds that underlay many of these investments are guaranteed by the federal government and are considered to have less risk than other bonds. In financial investments, instruments that can potentially give the highest yields are probably those that carry the highest risks. 

Fixed annuities offer investors stable returns at a low risk. However, because the risk is low, the expected returns may also be low.  You may opt for instruments with higher potential returns.  There are other options but your risk exposure will likewise increase.

For example, investing in mutual funds may yield higher returns.  However, unlike in a fixed annuity contract, the returns are not guaranteed.  If the fund you invested on fares badly in the market, you incur losses instead of gaining steady profit. This is why when the investment climate is turbulent or becomes unpredictable, many investors slow down and put more money on these low risk plans as opposed to other financial instruments because this is a safer way to receive fixed income.  But regardless of the market situation, many investors include them in their portfolio for stability.

Perhaps one of the biggest risks to a fixed annuity is the exposure to default in payment.  A default occurs when the insurer or the responsible financial institution fails to pay the annuitant the amounts specified in the contract, whether due to bankruptcy or for any other reason.  In the event of a default, losses may be considerable depending on how much of the entire account was defaulted.  It is recommended that you buy only from reputable companies to minimize this risk.  You may encounter some companies that will offer very lucrative and enticing packages but if they do not have a good track record to show, immediately say no.

Another factor to consider when investing on fixed annuities for the long term is inflation.  Because of the “fixed” nature of this policy, amounts to be paid out to you, say 10 years from now is already pre-determined.  There is no guarantee that the fixed amount you will receive then will have the same purchasing power as the money you are investing today.  Depending on the actual inflation rate that will prevail for the next 10 years, the amount you will receive may have either more or less.

To address the concern on rising inflation rates, some insurance companies are now offering a new rider, the Cost of Living Adjustment (COLA).  This provision will cover for the additional payouts based on inflation rates. The COLA may be paid for as part of the annuity contract or may be purchased separately.

When investing, it is always a very good strategy to get as much information on various products first.  Spend time understanding the various features and comparing them before deciding and making a commitment.  Know all the advantages and be wary of the risks involved. You owe it to yourself to make the wisest choice of investment possible because you worked hard for that money.

Annuities are best suited for long term investors.  Any withdrawal prior to age 59 ½ is subject to a 10% tax penalty as well as regular income tax.  Annuities often also have a surrender schedule, meaning that withdrawals may be subject to a penalty by the insurance company if not left in for a predetermined amount of time.  Any guarantees on principal invested are based upon the claims paying ability of the underlying insurance company.