Equity-Indexed Annuities: Consider This

Equity-indexed annuities, also known as indexed annuities, provide retirees with a minimum investment return with the added chance of stock-market gains. While the concept sounds perfect for most people, these products have been met with harsh criticism mainly due to heavy fees, opaqueness, lack of liquidity and disappointing results. But according to a recent Yahoo! Finance article, equity-indexed annuities are still very attractive to those looking for safety while hoping for inflation-beating gains.

“An index annuity is absolutely appealing in this environment, because we are at an all-time high, said Ty J. Young, a financial advisor in Atlanta. Young is referencing stock prices, corporate revenues and stocks’ price-earnings ratios. “Many folks are therefore looking for a place they can have their money protected and have it growing at the same time. An index annuity does that for them.”

But the debate over these products is far from over. Here’s a look at five key considerations to ponder when thinking about equity-indexed annuities.

Modest Yield

Many index annuities provide a guaranteed annual yield of a modest 1-3%, plus any gains linked to a stock market index, such as the Standard & Poor’s 500 index. It’s wise for investors to hope that they can earn more with their invested money than in certificates of deposit, money market funds, or bonds, with limited or no risk to their principal.

“There are many variations on how insurance companies create such contracts with their customers, but all of them support the limiting-downside-risk-by-muting-potential-upside-gains theme,” said head of partnerships at True Link Financial, Ryan Johnson. “It’s like bowling with bumpers in the alley. There is no glory but at least you won’t throw a gutter ball.”

They offer a safety net.

According to Bruce A. Sanders, financial advisor with Waddell & Reed in Alpharetta, Georgia, indexed annuities work well for “those seeking protection in a falling market, who have a long-term investment goal, and who have maxed contributions to other retirement plans…and need a tax-deferred investment vehicle.”

Young individuals, who have time to ride out the ups and downs of the stock market are not as likely to benefit from indexed annuities. Older retirees who are willing to trade some investment gains for protection of principal are really the target audience. They also become more popular during times of market volatility, such as the transition of a new administration, rising interest rates, uncertainty in energy markets and international tensions.

They can be confusing.

The most common criticism stems from the complexity of annuity products.

“Beyond understanding how the return is actually calculated, potential investors need to look at the annual fees the insurance or annuity company charges,” said Coleen Pantalone, finance professor at the Northeastern University’s D’Amore-McKim School of Business. “Investors also need to look at the surrender charges — what happens if you want out of the investment? These are long-term investments and you are usually penalized by the annuity seller for pulling out early.”

Be aware of caps and participation rates.

With many indexed annuities, investors do not receive 100% of the stock market gains. For example, if the index rises by 10%, the annuity has a 3% cap, the investor would only receive 3%, according to Fidelity. Additionally, there may be a “participation rate” applied, where the account will get credited for only a portion, let’s say 80%, of the index’s gains below the cap.

So while an indexed annuity offers a guarantee against loss of principal, which the stock market can not provide, investors do not receive dividends as they would with an index fund. You can not compare the two.

Indexed annuities should not replace bonds.

Index annuities can add diversification to a broad portfolio that includes stocks and bonds, but many advise against using them in place of bonds.

There is no tax deduction on money put into an indexed annuity, like with a 401(k) and many traditional IRAs. Withdrawals of interest earnings are taxed as ordinary income too. And there are no “step-up’ in basis for heirs either.

“Smart marketers on both sides of the business have learned that extremism works — picking villains works,” Johnson said. “Are (these products) right for everyone? No. Are they always bad? No. It all depends on each individual’s situation, how such a strategy or product fits into their plan, and their capabilities as an investor.”

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