Equity-indexed annuities are an innovative product available on the retirement market that may present both advantages and disadvantages. Their aim is to protect against market declines while simultaneously mitigating sequence risk that arises when withdrawals begin before recovery periods have concluded.
However, certain factors can impede your index-linked returns, including cap rates and participation rates.
Guaranteed Minimum Return
An equity-indexed annuity offers both a guaranteed minimum interest rate and returns tied to market index performance – often the S&P 500 index as examples of such products.
Return on EIAs depends on how much an index increases year over year and on how much the insurance company caps that gain. A participation rate or cap limits how much investors could gain as the index continues to rise; any investor’s potential gains can only amount to a small portion of index growth.
Sarah has invested at an 80% participation rate, meaning a 10% gain in the S&P 500 would only yield 9% return for her annuity investment. Additional restrictions such as rate caps can severely limit an investor’s earnings potential; this can be particularly harmful to someone seeking both safety and returns in one. Indexed annuities typically come with surrender periods between seven to 10 years during which any early withdrawal can incur penalties from insurance providers.
Fees
Equity-indexed annuities incur several fees. First and foremost is commission, charged by the insurance agent who sells you an annuity. Also applicable are surrender charges should funds be withdrawn prior to completion of their initial contract period; participation rates, caps, and spread fees that reduce index-linked earnings could also apply.
Mortality and expense risk charges, which compensate the insurance agency for taking on risks when offering annuity policies, may also incur fees that reduce earnings – these include mortality/expense risk charges as well as mortality/expense risk fees charged by insurance agencies for offering annuities to consumers. Finally, spread/margin/asset fees subtracted from your earnings via an annuity can take their toll as percentage subtraction from index-linked gains; for instance a spread/margin/asset fee subtracted directly from gains within that market index linked annuity an annuity provides exposure.
Contract Changes
Sarah values principal safety above all else, yet is open to the possibility of higher returns. An equity-indexed annuity may be suitable as it allows for growth while simultaneously protecting her principal.
An annuity’s contract typically includes a participation rate, which determines how much of the index’s gains will be transferred each year to its payouts. Additionally, this figure can include a “cap,” which restricts how far up it can rise at once.
A floor limits how low an index can drop over a given period, protecting against steep losses. Some contracts also offer buffers – a percentage loss an insurer is willing to absorb before deducting value from an annuity contract; these may be included as either part of its index-instruction formula or specified as fixed rates in contracts; this limit can have detrimental effects on annuity returns and is often included to offset any effects of market recession.
Long-Term Investment
An indexed annuity’s downside protection comes at the cost of reduced returns; generally speaking, they pay out between 1-3% of your premium as guaranteed minimum payments to you with any excess being invested into an equity index.
If the index rises, you’ll receive a portion of those gains (known as participation rate) credited back into your annuity. Caps may limit how much the index gains – for instance a 10% cap would prevent it from exceeding more than 9% growth per year.
Many retirement investors choose an indexed annuity for at least part of their savings because it allows them to track the market without incurring any downside risk to principal. There are other alternatives which offer greater potential returns such as guaranteed interest payout annuities and bonds; but keep in mind they typically aren’t tax-deferred like an indexed annuity would be.
