Indexed annuities are a class of annuities wherein the returns on them are yielded on your contributions and are based on specific equity-based indexes. They are typically purchased from insurance companies and are similar to other types of annuities. The payout conditions and terms depend on how they are defined in the annuity contract. Additionally, there will usually be provisions for a guaranteed rate of return issued by the insurance company that you purchase the annuity from.
Even if the index of the stock performs poorly, the annuitant’s level of risk of loss is somewhat limited. However, it is also common (occasionally) that the annuitant’s yields may be lower than what was initially expected. This is primarily due to the fact that the combination of “caps” on the maximum amount of earned interest and deductions that are classified as being fee-related. As with other annuities, you want to do your homework and determine whether or not indexed annuities will benefit your financial situation or not.
Advantages and disadvantages
Annual reset – the earned interest is annually guaranteed or “locked in”, while the value of the index is typically “reset” at year’s end. Normally, any future decreases in that index value does not affect the earned interest. Therefore, the indexed annuity that employs the annually resetting method might credit more interest to those annuities that employ other methods. This applies to fluctuations in the value of the index, both down and up, usually during the annuity’s terms. This type of method is more likely to provide access to interest which is indexed-linked before the end of the term compared to other methods.
Conversely, the participation rate (what you pay into the annuity) may fluctuate annually and is typically lower than the rates of other methods for indexing. Usually, these annual reset methods might employ a cap or an averaging to the limit of the total annual earned interest.
High-water mark – usually the highest value of the index on the anniversary of the contract’s term is how the interest is calculated and arrived at. It may credit a higher rate of interest than other indexing methods if that index attains a higher value earlier or in the middle of the contract’s term. Then, at the end of the term, it drops off.
The downside is that earned interest is calculated at the end of the contract’s term. However, with some annuities, you may not receive interest that is index-linked for that term should you surrender that annuity prior to the end of its term.
Point-to-point – since the earned interest is not calculated prior to the end of the contract’s term, an indexed annuity usually permits a higher rate of participation than annuities that use other methods.
The typical term of annuities is 6 to 7 years and since the earned interest won’t be calculated until the end of the contract term, you might not be able to receive that index-linked interest until the term is complete.