Indexed Annuities Pros and Cons

First, some important clarification:

When you are reading, you will see both ‘Fixed Indexed Annuities’ and ‘Equity Indexed Annuities.’  These refer to the same product!

It is confusing for advisors and clients alike, so don’t feel bad!  The correct term, however, is Fixed Indexed Annuity as this is squarely an insurance product, and not a security.  The term ‘Equity Indexed Annuity’ infers an equity component and thus more in the realm of a security offering. While there is a push to  regulate these annuities as securities, as yet this has not happened.

Are you ready for a general overview of index annuities?

Index annuities offer principle guarantees with potential growth tied to a major stock market index.  You’ll get your money back in the worst-case scenario and you may profit nicely if things go well.

In order for these contracts to work there are several components that work for or against you.  So let’s get started…

Indexed Annuities Pros and Cons: First, the Pros:

Principle and Growth Guarantee- Your initial investment is secure and guaranteed to grow at a low rate.  The contract will state the minimum amount you can expect to receive at the end of the surrender period.

Tax Deferral- Like all annuities, your money grows on a tax-deferred basis.

Account Step Ups- In most cases, a new base contract value can be locked in when the index performs well.  This gives you the benefit of locking in a new guaranteed basis when the market works the way we all want it to.

Indexed Annuities Pros and Cons: Now for the Cons

Capitalization Rates- All contracts state the maximum amount of interest that will be credited to the account.  This can be calculated in a variety of ways such as on a monthly or annual basis.  With an annual cap rate of 9%, the market index may return 20% but the account will only be credited with the maximum cap of 9%.

Participation Rates- All contract also stipulate the percentage of the index gain that will be credited to the account.  This will range from 60%-100%.  If the index gains 10% and the contract has a 60% participation rate, the account will be credited with 6% interest.  This is also subject to the Cap Rate where applicable.

Long Surrender Periods- These contracts often have very long surrender periods.  One reason for this is the fact that you have a better chance for favorable index performance over a longer period of time.  Even so, if you have a time horizon of more than 10 years, the principle guarantee may not be as important.

Let me state for the record that I have yet to see a good indexed annuity with a long surrender period.  For instance, one of my favorite products in this category has a five-year surrender period.  If you happen to really like it after five years, then buy it again and make it a ten-year strategy.  If it doesn’t work that well then you’re money is free a lot sooner.

Crediting Methods- This determines how the index return is credited to your account balance and can have a dramatic effect on the performance of the annuity.  Two common methods used are monthly averaging and point-to-point.  The averaging method will credit the monthly index average to the accont.  The point-to-point method will compare the starting and ending values of the index, on a monthly or annual basis, to determine the total return to the annuity account.  Also, for additional fees, a highwater mark feature can be added to point-to-point option so you can look back over the period and take the highest value for crediting purposes.  All crediting method options are subject to participation and cap rates.

This is a very basic approach to the complexities of fixed indexed annuities.  Do yourself a favor- sign up to the right and get The Annuity Report for free.  You need to understand your needs first, and only then look at a specific product type.  And now armed with the indexed annuities  pros and cons, you can meet an advisor on a level playing field. In reality, the real analysis begins when you are presented with an individual contract.

Fixed Indexed Annuities can seem complicated type of annuity when the average salesman presents the typical product.  I can’t stress enough the importance of an expert advisor when these are being considered.  Beyond just indexed annuities pros and cons, a competent advisor can actually explain how these products work and what specific value they hold for you.  With a reasonable explanation, it’s easy to see the pros and cons of indexed annuities for conservative asset management.