Up until very recently, individuals had two choices when it came to annuities: fixed annuities (offering a guaranteed rate) and variable annuities. But in the mid-90s, a third option was introduced that has begun to gain in popularity: the index annuity.
Index annuities are designed to mirror the performance of a common or well-known index, such as the S&P 500, Russell 1000 Index, or the S&P 100.
By tracking a popular index, owners of index annuities can participate in general market changes, while being able to easily track ups and downs in the annuity’s value.
Issuers of index annuities always specify the level at which index annuity owners wil be “in the market.” This level is called the participation rate, and reflects how closely the annuity follows the index’s performance.
Participation rates are quoted in terms of a percentage. Suppose an index annuity has a defined participation rate of 70%. If the index it follows goes up by 8%, the annuity’s accumulated value increases by 5.6%. And in many index annuities, the insurance company mitigates downside risk.
Everyone loves bull markets but when the indices head south, no one likes losing money. Insurers know that all to well. That’s why they will often specify “floors” that the annuity cannot go below.
For instance, many insurers state that, no matter how the index performs, the annuity owner will never receive less than they originally deposited. Some institutions go one step further and even ensure that the annuity value will always increase in value by a minimum annual interest rate (usually 1-3%).
To pay for these promises, any growth comes with a spread. The spread is the difference between what the annuity funds actually earn, and the amount that is credited.
Spreads are not new, and they are not restricted to annuities. When you open a savings account, you are subject to a spread. The bank may be earning 5% on your money, but in a savings account, they’re only paying you 1%. In this example, the 4% difference is the spread.
In the case of index annuities, the annual spread can range anywhere from 1.5% to 5%, and is clearly reflected both in the initial contract, as well as the statements issued by the insurer.
Index annuities are, at their very heart, an annuity. They are tax-deferred, meaning that you don’t have to pay taxes on your gains until you actually make a withdrawal. Since they are meant to be used as retirement vehicles, they are designed to be held for the long-term.
Withdrawals made by an annuity owner under age 59 1/2 are subject to a 10% penalty by the IRS, as mandated by Congress. Excessive withdrawals made before the index annuity matures can also incur a fee. Insurance companies impose “surrender charges” if annuity funds are withdrawn before the contract expires.
Most insurers, though, will allow a certain amount to be withdrawn every year without penalty. Some even allow free withdrawals in the event of a nursing home emergency.
With the surge in popularity of index annuities, more insurance companies have designed their products to be index annuities. As a result, picking and choosing the right index annuity can sometimes be a difficult decision.