Understanding Indexed Annuities

When investors enter into a contract for purchasing an indexed annuity in exchange for a future payment amount, they agree to future distribution that is yet to be determined by the market’s performance. This slight variation from other annuities, often deem them more complex investments within the annuity family. Indexed annuities are contracts between the investor and the insurance company, and can be viewed like other similar investments vehicles in that they have a payment or “accumulation” phase, as well as a payout or “distribution” period.

After the accumulation period occurs, the insurance company will make installment payments or a “lump sum” payment to the investor after determining the final payment agreed upon under the terms of the contract. Gains during the accumulations period are protected from taxation on a yearly basis up until the investor makes his first withdrawal, making this an exceptional favorite among many investors.

Since the rate of return for the investor relies on the performance of the index market, it is possible for the investor to ultimately get less in return than what he actually paid into the annuity – again, depending on the terms of the contract and the market. Further, if index annuities are cashed out before maturity or a specified date, then significant fees and penalties will apply.

Depending on the contract features of the indexed annuity, these investments may or may not be registered with the SEC. Typically for SEC registered securities, for example, the insurance company must provide a minimum rate of return for the investor. This is not always guaranteed due to the inherent nature of market fluctuations and the type of investment. However, index annuities provide a viable option for investors who would like to diversify their portfolio and peg their earning directly to the performance of the market with a particular investment vehicle.

As with other savings vehicles, the investor should know several key features to the index annuity before entering the contract with an insurance company, such as the margin or the administrative fee, which can take a take a portion of the return during the distribution phase. Take for example an indexed annuity contract with the margin fee of say 2%. A margin fee may be considered an “administrative fee” to handle the account. This fee will could chip away at your overall return. For a brief illustration, if the index or market’s performance gained 12% over certain period of time, the result would be 12% – 2% of margin fee to equal a 10% return for the investor.

With index annuities there may also be ceilings, or the maximum rate of interest which can be earned by the investor. Say for example that the interest rate ceiling or “cap” for a particular contract is set at 9%, and the market grows 14% over a determined period of time, the investor would only be compensated only 9% and not the 14%.

Since annuities are not backed by the FDIC, investors who purchase annuities should be aware of the inherent risks due to the volatility of the market. Index annuities are particularly sensitive to the market’s performance. An assessment of risk should also be determined for particular strength and stability of the insurance company in question.

Nevertheless, index annuities are a great option for the long-term investor who would hedge a percentage of their future retirement income stream based on the market’s historical trend for increased growth.