Annuities

When the markets are volatile and the interest rates low, investors turn to relative safer investment options such as an index annuity. Let us quickly try to understand the term and what are the advantages and disadvantages of investing in this kind of an investment vehicle. An Index annuity is an investment vehicle which is closely linked to some leading index such as the S&P 500. If the stocks rise then investors benefit from the rise in stock prices. If the stock markets fall, investors are safeguarded against the falling stocks which assure a minimum return of 3%.

This is the biggest advantage of an index annuity. While on one hand an investor gains from rising stocks a falling market does not erode the base capital and still ensures a small return. Financial institutions which have annuity products make their money from the spreads. In a rising market they make more profits than what is passed down to the investor. The profits so accrued during a bull market are used to compensate investors during a bear phase.

The index annuity is a relatively newer product in the annuity space. Earlier annuity products only varied around variable equities and fixed annuities which invested the funds in secure investment vehicles.  Index annuities are good investment vehicles for investors who have a long term investment horizon. Of all the products that are offered by annuity companies the investments have a lengthy time frame (5 years or more).  So if an investor is ready to invest for a long term then index annuities can be a good bet.  There are features such as the “annual reset” rate which is used to lock-in the rate of interest.  In other words the financial institution which is issuing the annuity product has a cap on the interest rates in times of bull phases.

The index annuity is an investment vehicle which is good for investor who have moderate to high risk appetite.  There may be instances when an equity market may go for a prolonged “bear” phase. In these kind of scenarios the returns that are generated from the equity will be consistently low over a period of time.  Investors who have sudden requirement of funds may want to withdraw the investments that have been already made into an index annuity fund. The investor may have to pay charges for early withdrawal. Before buying an index annuity an investor should be aware of all the features of the product before taking the plunge.

Companies selling index annuities will offer features which may not be significantly different. However, when buying a product an investor should look for features which suit their individual requirements.  Representatives may try to hard-sell a product but as investors we need to take informed decisions.  An index annuity product may be a good fit for a young investor who wants to invest in for securing financial needs after retirement.  Of other annuity products available in the market,  an index annuity can give good returns in the long-term. So, do your study before you make the choice. Get help from an experienced retirement advisor who can help you compare several offerings.

But the current timing makes the index annuity a particularly opportune retirement option because if the market jumps from these low levels, you share in the gain yet you have protection of your principal if the market slumps.  Select a very solid insurance company, rated AA or AAA by Standard and Poors.

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Fixed annuities guarantee your income based on current interest rates. Facing a long retirement horizon, you may want to consider relying a little on the markets to enhance your annuity income. An equity-index annuity offers that chance, but you must understand how it works.

Equity-index annuities  combine features of traditional insurance products (guaranteed minimum return) and traditional securities (where the return is linked to equity markets). Depending on the mix of features, an equity-index annuity may or may not be a security. In fact, the typical equity-index annuity is not registered with the SEC (but may be in the near future and become classified as a security).

Here’s how they work:
During the accumulation period – when you make either a lump sum payment or a series of payments – your insurance company credits you with a return based on changes in an equity index. The S&P 500 is a typical index although some equity index annuities may be based on indexes such as EAFE, he NASDAQ 100 or the Wilshire 5000.

The insurance company typically guarantees a minimum return of 90% of the premium plus a minimum interest rate. With an equity index annuity,  surrender charges can last for several years, and it is possible to lose money if the investor cancels the policy in the early years or does not earn index-linked interest. If there is no increase in the underlying index during the designated term, investors receive only the minimum guaranteed rate minus expenses and withdrawals prior to age 59½ are subject to 10% penalty.

After the accumulation period, the insurance company will make periodic payments to you unless you take your contract value as a lump sum.

Understanding how the interest rate used in your contract is linked to the equity index determines what advantage you really get over a fixed annuity. Consider these procedures in the linking process:

Participation Rates: The participation rate determines how much of the index’s increase will be used to compute the index-linked interest rate. For example, if the participation rate is 75% and the index increases 10%, the return credited to your annuity would be 7.5% (10% x 75% = 7.5%).

Interest Rate Caps: Some equity-indexed annuities set a maximum rate of interest that the equity-indexed annuity can earn. If a contract has an upper limit, or cap, of 7% and the index linked to the annuity gained 7.5%, only 7% would be credited to the annuity.

The Margin, Spread, or Administrative Fee: The index-linked interest for some annuities is determined by subtracting a ‘fee’ percentage from any gain in the index. This fee is sometimes called the “margin,” “spread,” or “administrative fee.” An annuity with a “spread” of 3%, will credit a return of only 7% if the index gained 10% (i.e. 7% = 10% - 3%).

The method of indexing the index change will affect your return too. A couple of indexing methods are:
Annual Reset (or Ratchet). This method credits index-linked interest based on any increase in index value from the beginning to the end of the year.

Point-to-Point. This method credits index-linked interest based on any increase in index value from the beginning to the end of the contract’s term.

Know the features of any equity index annuities you consider to see their impact on your annuity’s potential return.  Use the fixed annuity calculator to get an estimate of your future value at different interest rates.

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