Up until very recently, individuals had two choices when it came to annuities: fixed annuities (offering a guaranteed rate) and variable annuities. But in the mid-90s, a third option was introduced that has begun to gain in popularity: the index annuity.
Index annuities are designed to mirror the performance of a common or well-known index, such as the S&P 500, Russell 1000 Index, or the S&P 100.
By tracking a popular index, owners of index annuities can participate in general market changes, while being able to easily track ups and downs in the annuity's value.
Issuers of index annuities always specify the level at which index annuity owners will be "in the market." This level is called the participation rate, and reflects how closely the annuity follows the index's performance.
Participation rates are quoted in terms of a percentage. Suppose an index annuity has a defined participation rate of 70%. If the index it follows goes up by 8%, the annuity's accumulated value increases by 5.6%. And in many index annuities, the insurance company mitigates downside risk.
Everyone loves bull markets but when the indices head south, no one likes losing money. Insurers know that all to well. That's why they will often specify "floors" that the annuity cannot go below.
For instance, many insurers state that, no matter how the index performs, the annuity owner will never receive less than they originally deposited. Some institutions go one step further and even ensure that the annuity value will always increase in value by a minimum annual interest rate (usually 1-3%).
To pay for these promises, any growth comes with a spread. The spread is the difference between what the annuity funds actually earn, and the amount that is credited.
Spreads are not new, and they are not restricted to annuities. When you open a savings account, you are subject to a spread. The bank may be earning 5% on your money, but in a savings account, they're only paying you 1%. In this example, the 4% difference is the spread.
In the case of index annuities, the annual spread can range anywhere from 1.5% to 5%, and is clearly reflected both in the initial contract, as well as the statements issued by the insurer.
Index annuities are, at their very heart, an annuity. They are tax-deferred, meaning that you don't have to pay taxes on your gains until you actually make a withdrawal. Since they are meant to be used as retirement vehicles, they are designed to be held for the long-term.
Withdrawals made by an annuity owner under age 59 1/2 are subject to a 10% penalty by the IRS, as mandated by Congress. Excessive withdrawals made before the index annuity matures can also incur a fee. Insurance companies impose "surrender charges" if annuity funds are withdrawn before the contract expires.
Most insurers, though, will allow a certain amount to be withdrawn every year without penalty. Some even allow free withdrawals in the event of a nursing home emergency.
With the surge in popularity of index annuities, more insurance companies have designed their products to be index annuities. As a result, picking and choosing the right index annuity can sometimes be a difficult decision.
To help you sort through the confusion, SaveWealth and its annuity experts have put together a checklist for you to use when selecting an index annuity for yourself: Here are some things to look for in your next index annuity:
- Strong Ratings
What kind of assurances and guarantees does the company make? Ensure it will be around when you need it most. Look for insurance company ratings of "A" (Excellent) or better.
- Fixed vs. Flexible Spreads
Is the spread fixed (and predictable), or does it vary from year to year? If an insurer has a bad year, they may have to increase the spread to make up for lost profits. That helps them, but could hurt you in the long run.
- Participation Rates
Higher participation rates are usually better. However, the benefits of a higher participation rate can be reduced by high spreads or long indexing periods. Make sure you read the fine print.
- Surrender Period
Index annuities typically have longer maturities than other annuities. Make sure the surrender period lasts no longer than 11 or 12 years.
- Free Withdrawals
Most companies offer 10% of your original annuity's value to be withdrawn every year, free of penalty. However, you should look for a company that offers a 10% withdrawal on the accumulated value, not the original value. Some index annuities also allow you to rollover withdrawals not used.
- Nursing Home Waivers
Make sure your index annuity allows you to pull out 100% of your contract if you are confined to a hospital or nursing home. The usual standard is 30-60 days of confinement to qualify for the free withdrawal. If you do not own long-term care protection, this is crucial.
- Death Benefits
Some contracts provide enhanced death benefits, should the annuity owner die before the contract has matured. The cost for these benefits is usually reflected in the spread. Make sure your contract promises either the accumulated value of your annuity, or the minimum accumulation (whichever is greater). Remember, annuity proceeds bypass probate.
- Indexing Period
Does your annuity track index changes on a month-to-month basis, or only at the end of the contract? Month-to-month can often lock in short-term gains in the market. Ask your SaveWealth Advisor for more details.
- Annuitization Options
What options does the index annuity give you for pulling your money out? Make sure you have plenty of options to choose from.
The great thing about index annuities is that you have plenty to choose from. Of course, the disadvantage about index annuities is that you have so many to choose from.
A SaveWealth Advisor can help you find out which annuity is right for you, based on your risk tolerance and how you think the market will perform. A SaveWealth Advisor can also further explain the differences between index annuities, and help identify which features are appropriate for you.