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Indexed Annuities Offer Benefits, But Be Aware of Drawbacks


Indexed annuity sales have been very strong over the past couple of years.  These annuities sometimes get a bad rap in the media so it may be hard to know if they are a product to consider for your retirement income planning or not.  Investor’s Business Daily published an article listing some of the benefits and drawbacks of fixed indexed annuity products.  In the Paul Katzeff article, “Pros, Cons Of Indexed Annuities,” he also summarized sales data from Wink’s Sales and Market Report.  Indexed annuity sales were $11.3 billion during the first quarter of this year.  That is 5% higher than the first quarter of 2014 and the highest sales figure that these particular annuity products have ever had in a first quarter.1

If you are considering purchasing an indexed annuity, you have to weigh their benefits against their drawbacks.  If their benefits bring you value and help meet the goals of your retirement income needs, the drawbacks might be worthwhile. Fixed Index annuities may be a good fit for people who are concerned about market volatility.

An indexed annuity is a contract between you and an insurance company.  It pays a fixed interest rate and also has the potential of higher interest rate earnings, based on the rise in an offered stock market index of your choosing.  Your earnings are credited at specified times, and once locked in, you cannot lose those values due to stock market volatility because you have no direct exposure to the market.  Interest earnings are tax-deferred until you start receiving income.

Many indexed annuities are subject to a maximum interest rate (cap), a percentage of the index gains you will be credited (participation rate), or a percentage of gain that may be subtracted (spread), so you are not always getting the full amount of growth of the index each year.  The average indexed annuity return when Fidelity looked at 10-year rolling periods was 3%, while the markets averaged a 10% return.2

Some people might argue that it’s better to invest directly in the index through a mutual fund or exchange-traded fund (ETF) and avoid the costs of an indexed annuity.  However, a main benefit of indexed annuities is that, in addition to a guaranteed interest rate plus the potential for paying out a higher return, you will not lose any principal if the index value decreases during the crediting term.  That certainly is not the case when investing directly in the markets.  Guaranteed lifetime income* is another benefit offered by many indexed annuity products.  You receive a lifetime stream of income payments starting at some point in the future.  Indexed annuities also offer simpler options when it comes to choosing your interest crediting strategy.  You typically choose from around 6 different indices that can be linked to your annuity.

While there are certainly benefits to indexed annuities, there are some drawbacks as well.  Sometimes the gap between the actual index return and the return you receive is large.  When considering any indexed annuity product, it is important to read the terms of the contract, and carefully consider its limitations and conditions. Some contracts reserve the ability to lower the cap, spread or participation rate offered during a given crediting period. The article goes on to say that indexed annuity returns are typically comparable to very conservative investment products, rather than to the stock market.1  So your fixed indexed annuity will grow more slowly, but will be protected.

Another drawback is the commitment time period.  Most annuities have a “surrender charge period” of 5 to 15 years.  After the first year, you may have some liquidity during this penalty phase, often having the option to withdraw up to 10% of your initial premium
each year.  However, if you take withdrawals of more than the “free withdrawal” amount in your contract, or surrender the annuity early, you will be charged a penalty.  Withdrawals before age 59-1/2 will also incur an additional 10% IRS tax penalty.  If you purchase a fixed indexed annuity, make sure you can commit that money for the long term.

The moral of the indexed annuity story is that you have to know your contract and exactly what kind of interest you are guaratneed, and what you may reasonable expect.  These products offer the benefits of guaranteed lifetime income and the potential for market returns without losing any of your principal if the markets decline.  But be aware of caps, spreads and participation rates that could limit your potential returns and the commitment of your premium to a long term.  Weigh the pros and cons of indexed annuity products to see if they are the right fit for your individual retirement income needs.

Written by Rachel Summit

Follow Rachel, aka Finance Mama, on Twitter and Google+


*Guarantees of annuities rely on the financial strength and claims-paying ability of the insurance company that issues them. Lifetime payouts may be a benefit of the base annuity contract, or may be offered through the additional purchase of a lifetime benefit rider.
2 “Indexed Annuities: Look before you leap. ”Fidelity, November 1, 2014. https://www.fidelity.com/viewpoints/retirement/considering-indexed-annuities
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