Annuities provide valuable options for individuals looking to save for retirement and receive retirement payouts based on marketing indexes. One popular type of annuities is equity-indexed annuities, which allow individuals to earn interest based on how a specific stock market performs.
While investing in equity-indexed annuities is a valuable solution for many people uncertain about how they’ll fund their retirement, these contracts have some caveats to consider before deciding. This article will help you ensure that you’re prepared to invest in an equity-indexed annuity by explaining what these annuities entail, what benefits you can access with this contract, and the potential risks associated with equity-indexed annuities.
What are Equity-Indexed Annuities?
Equity-indexed annuities are one of the various types of annuities and allow individuals to earn interest based on the fluctuating performance of a specific stock market equity index, such as the S&P 500. This contract is a type of fixed annuity. It is most distinguishable because of its ability to help conservative investors have a chance to earn more returns on their investments than traditional fixed-rate annuities.
While equity-indexed annuities are slightly riskier than traditional fixed annuities, they still provide some protection against a market’s downside risk and are safer than variable annuities. While they differ from variable annuities, equity-indexed annuities are a hybrid of traditional fixed and variable annuities.
How an Equity-Indexed Annuity Works
Once you have signed an indexed annuity contract, your insurance company invests your funds into your stock market index of choice. Depending on your situation, you may invest in a single index or across numerous indexes to increase your interest earned.
These annuities limit the amount you can earn in a specific period and are typically less risky than direct investments in the stock market. However, the diminished potential for profit gains comes with this reduced risk.
By investing in an indexed annuity, you can receive periodic payments from your insurance provider as a return on the amount you’ve paid on your premiums. During the accumulation stage, before the distribution of your funds, your paid premiums earn interest with a guaranteed minimum amount, typically between 1% to 3%, on 90% of premiums paid.
How do Equity-Indexed Annuities Differ From Traditional Fixed Annuities?
Though equity-indexed annuities are a type of fixed annuity, they differ from traditional fixed contracts in some critical ways. Ultimately, the primary difference between a traditional annuity and an equity-indexed contract is how this contract credits interest to your value.
Equity-indexed annuities accrue interest by calculating your rate based on changes in the market index. Therefore, the additional income you earn with an equity-indexed annuity depends on specific features of your contract and the market index.
Index-Linked Returns
Equity-indexed annuities pay returns depending on overall index gains and performance. The rate of return for indexed annuities does not always match the index-linked return rate, meaning that individuals could get a return significantly lower than the index linked to their annuity.
Because specific limitations restrict returns, many people are dissatisfied with their earnings. Contractual restrictions on your rate of return are evident in three ways: participation rates, interest caps, and a spread, margin, or asset fee.
Below is a breakdown of each factor and how they can limit the return rate on your equity-indexed annuity.
Participation Rates
Your contract’s participation rate describes the percentage of a market index’s returns credited to your annuity. For example, if your annuity’s participation rate is 75%, your index-linked returns would equal 75% of the associated index gains.
Interest Caps
Another element contributing to equity-indexed annuity limitations are interest caps. Interest caps mean that when the stock market index rises significantly, investors with this contract won’t have this increase reflected in their returns.
For example, if a market index rises by 15%, but an individual’s annuity cap maxes out at 6%, returns are limited to no more than 6%.
Spread, Margin, or Asset Fees
Indexed annuity contracts often use spread, margin, or asset fees rather than a traditional participation rate. With this option, the percentage of your rate is subtracted from index-linked gains.
Therefore, if an index rises by 10%, but your fee is 3.5%, you will only gain 6.5% in your annuity.
What are the Benefits of Equity-Indexed Annuities?
Though any annuity contract has risks, equity-indexed annuities have various benefits to consider if you’re interested in fixed-indexed annuities. Equity-indexed annuities can help you earn a higher rate of return, improving your financial health and preparing you for retirement. Consider some of the benefits below when deciding whether an equity-indexed annuity suits you.
Participate in the Upside, Protect Against the Downside
One of the primary benefits of an equity-indexed annuity is its ability to help you participate in the stock market upside and earn more when the market improves while protecting you from significant losses during a stock market downside.
Because of the guaranteed minimum return involved with equity-indexed annuities, individuals can earn more than they would with a fixed annuity and eliminate the risks of variable annuities.
Lifetime Income
Because it is a fixed annuity contract, investing in an equity-indexed annuity means you will have access to a source of lifetime income. By annuitizing this contract in your retirement, you can ensure guaranteed income for your lifetime or over a specific period. In addition, these annuities include an annual reset, meaning your earnings are credited yearly.
It’s important to note that indexed annuities have a specific period for surrender charges. This period typically lasts up to 10 years when you have minimum or no liquidity. Withdrawing early from your contract can incur surrender charges and a costlier tax penalty than you’re comfortable paying.
Grow Tax-Deferred
Individuals with an indexed annuity can grow tax-deferred market gains until withdrawing funds upon retirement. This factor allows you to accumulate money faster and see more significant investment returns.
Can be Passed to Beneficiaries
Another benefit of indexed annuities is that you can pass down your remaining funds to a beneficiary upon your passing. With this annuity, you won’t have to worry about securing probate or your heirs struggling after your death.
What are the Downsides of Equity-Indexed Annuities?
Like any annuity contract, indexed annuities have certain downsides that might make them unsuitable for your financial situation. Below are some of this contract’s most commonly cited downsides to help you determine whether to consider different types of annuities rather than an equity-indexed annuity.
- Complexity: equity-indexed annuities can be incredibly complex as investment vehicles, making them challenging for some investors to understand. Additionally, with proper knowledge of the terms and conditions of your contract, you may be able to make better decisions regarding your annuity.
- Doesn’t match an index’s total return: another issue you might encounter with this contract is that an equity-indexed annuity doesn’t always meet an index’s total return amount. Some policies provide only a portion of the index’s return, and many exclude dividends from your gains.
- Surrender charges: surrender charges can incur hefty fees resulting from terminating your equity-indexed annuity. Surrender charges may reach as much as 20%, lasting over 15 years.
- Limited upside potential: while an equity-indexed annuity is a valuable balance between traditional fixed annuities and variable annuities, it only allows for limited gains during market upsides. If the market performs well, you won’t benefit as much as possible from other options.
Deciding Whether an Equity-Indexed Annuity is Right for You
Determining whether an equity-indexed annuity suits your financial situation is possible with a few considerations. By understanding these products, you can improve your chances of making a wise investment that supports you for life. Consider the following questions before deciding whether to invest in this type of annuity:
- How much retirement income do you need besides what you will receive from Social Security and your pension plan?
- Will you require supplemental income for others and yourself?
- How long are you planning to leave your money in the annuity?
- When will you start to require periodic income payments?
- Depending on when you’ll need access to your funds, will an annuity allow you access when necessary?
- Is a fixed annuity with a guaranteed minimum interest rate suitable for you over a variable annuity with the potential for higher earnings?
- Are you seeking a middle ground between a traditional fixed and variable annuity?
How Can I Invest Wisely?
Deciding whether to invest in an annuity contract is a significant decision for many adults. While fixed annuities are safer than variable annuities, they still maintain certain risks that could cause financial damage if you are not careful with your investments.
Ultimately, the best way to make wise investments is by consulting a financial professional, such as an attorney, advisor, or certified public accountant. Equity-indexed annuities can be excellent retirement tools if you approach your investments cautiously and base your decisions on the advice of an expert.
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