Indexed Annuity

You are looking for a guaranteed stream of income but you are not willing on quitting the stock market returns yet? Indexed annuities may be part of the answer for you. By definition, an indexed annuity investment return is linked to a market index. The most common index is the S&P 500.

 

indexed annuities

How Indexed Annuities Are Structured

 

As opposed to fixed annuities, indexed annuities investment return is not known at the purchase time. Your initial investment is secured and you will not lose money through such contracts. There is also a minimum investment return included in indexed annuities. How can you be 100% sure to make money with an indexed annuity if the rate of return is linked to a market index? The answer to this question lies in the contract structure.

 

In order to provide a variable return linked to the S&P 500 for example, the indexed annuity contract  is separated in two parts:

 

indexed annuities structure

 

The fixed annuity inside the contract provides a guaranteed income stream as any regular contract. This is how the Life Insurance Company is able to provide you with a minimum investment return. The second part of the contract is invested in call options to buy the selected index (the S&P 500 for example). A Call option is a contract enabling the owner to purchase an index at a specific price.

 

If the index goes up, your annuity payments will be increased by the profit realized with the call option. If the index goes down, the call option contract will expire and no gains or losses will incur. Please note that the money used to purchase the call option is loss.

Main Advantages

 

Downside Protection

As explained previously, if the index goes down, you will not lose money on your investment. The fixed annuity included in your contract is your safety net against such events. An investor who bought a variable annuity at the beginning of 2008 still received payments after the crash and didn’t lose any money. On the other side, another investor who would have preferred to keep his money invested in the stock market and derive an income from it would have lost a fair chunk of his nest egg.

 

Better returns than CD’s

Since the stock market is reputed to outperform certificates of deposit and bonds, indexed annuities also offer better returns. Given the current interest rate market, your chances of outperforming safer investments such as CD’s with an indexed annuity are great.

 

Possibility of following / beating the inflation

One of the main risks for retirees is to be able to keep up with inflation. Since you stop working, your ability to increase your income is solely link to the return of your investments. Inflation is expected to be around 2.25% over a long period of time. This means that if you want to keep the same lifestyle you have today, your investments must at least generate 2.25% each year. Indexed annuities are built to follow and possibly beat inflation overtime in order to secure your investment.

 

Main Disadvantages

 

I’ve written many times that there are no free lunches in finance and indexed annuities are no exceptions. Security and potential higher income comes with a price.

 

Limited Upside with no dividends

If you look at the S&P500 returns over a year and you take your annuity statement, you will notice that your contract didn’t follow exactly the index. In fact, your investment return will trail behind. Since not all your money is invested in call options, you can’t expect to match the index perfectly. Also, keep in mind that call options don’t cash dividend paid by companies included in the index. Since 53% of the overall S&P500 return comes from dividend payment, you will miss a great deal with such contract.

 

Surrender charges and other fees

Surrender charges are particularly high if you want to cancel your contract. Most contracts include surrender charges over 10 years. Fees included in such contract are far from being low.

 

It’s pretty complicated to understand… even for the adviser!

Due to its duality (fixed vs call options), indexed annuities are fairly complex… even for some advisers. Do not hesitate to ask many questions to your rep to make sure you understand the product… and the he does too! Don’t let you blinded by some fluffy graphs and income projections.

 

Final Thoughts on Indexed Annuities

 

Indexed annuities were built a few decades ago with one goal in mind: compete against CD’s return. This is not a growth seeking product because the potential gain is limited. Indexed annuities could be used as a complimentary product within your annuity structure.

 

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