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Is an Indexed Annuity Right For You?

Given recent market volatility, it’s no surprise that many investors have lost their appetite for risk, even for those still accumulating assets. Of course, it’s important not to jump ship at the first sign of a market shift, but if your financial plan allows for adjustments, now might be an appropriate time to look into other investment options.

Perhaps now is the time to review your risk allocation. One financial expert recently suggested (in an article from The Street) cutting back from a 60% stocks, 30% bonds, and 10% cash portfolio, to a 50-55% stock allocation. Or is it time to consider a variable annuity, which offers some guaranteed minimum accumulation benefit?

According to Kaplan Financial Education, an equity-indexed (EIAs) or fixed-index annuity (FIAs) might be most suitable for those who want to participate in equities market without the investment risks or costs of a variable annuity. These products provide a guaranteed minimum return with the ability to earn a return based on changes in an equity index, like the Standard & Poor’s 500 composite stock index.

It’s true, these products sound almost too good to be true, with the upside potential and downside protection, which makes reading the fine print even more important. According to Kaplan Financial Education, there are several factors that are used in computing the interest rate of these products, which include:

  • The floor: the minimum rate credited to the contract, regardless of index changes.
  • The participation rate: the rate that determines how much of the increase in the value of the underlying index will be used to compute the interest rate credited to the contract.
  • Interest rate cap: the maximum rate of interest the FIA/EIA can earn regardless of the participation rate and actual index return.
  • The spread or administrative fee: The interest for some FIAs is determined by subtracting the percentage of up to 3% from any gain in the index.

Financial planner and president of Reid Financial Consulting, Marty Reid, thinks that the most appealing features of the EIA/FIA are the guarantee of no loss of principal and participation in equity markets.

“However, as attractive as EIAs/FIAs might sound, the product includes both costs and limitations,” he stated. “While insurance companies may tout that the EIAs/FIAs have no internal costs, they make their profit by retaining the spread between its capped investment return and the actual return of the equity index.”

For instance, if the S&P 500’s annual return is 15%, and the contract’s capped return is 7%, the insurance company retains 8% to cover their expenses.

“In addition , EIAs/FIAs usually have long surrender periods, lasting seven to 10 years,” Reid added. “So, if you surrender your contract early, you may incur surrender charges.”

Reid also warns of the annuity’s tax treatment. Realized gains are subject to ordinary income tax, and withdrawals taken before age 59 ½ are subject to a 10% penalty. Additionally, the “participation rate,” which calculates its investment return, is a fairly confusing feature, considering various methods are employed and vary from contract to contract.

So when is an EIA suitable? According to Reid, a retiree who is risk averse and is seeking to hedge against outliving their money might want to consider adding one to their portfolio. In addition to being sure you understand the costs, features, risks and limitations of an annuity contract, Reid also recommends reviewing your retirement plan with a certified financial planner “to help determine what strategies and products are the best fit for your financial situation.”

For more information about variable, fixed-indexed or any other annuity product, visit our website, www.annuityfyi.com. Questions or comments? Call us at 1-866-223-2121, or send us an email at support@annuityfyi.com.

Written by Rachel Summit

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