Before purchasing an indexed annuity, it is important to understand various contract
features and their potential impact on annuity performance.
The Index
Indexed annuities credit interest based on the movement of the
stock market index to which the annuity is linked. A market index
tracks the performance of a group of stocks representing a
specific market segment or the entire stock market. The S&P 500
is the index most commonly used for this purpose. Another
index, however, may be used, such as the Dow Jones Industrial
Average, NASDAQ 100 or Russell 2000. It is important to
understand that when you buy an indexed annuity, you are
purchasing an insurance contract and not shares of any stock or
index.
Indexing Method
An indexed annuity earns a minimum rate of interest and then
offers the potential for excess interest earnings based on the
performance of the index to which the annuity is linked. The
indexing method is the approach used to measure the amount of
change in the index and, as a result, has a direct impact on the
potential growth of an indexed annuity. Additional information is
available on page 8.
Participation Rate
The participation rate determines how much of the increase in the
index will be credited to the indexed annuity. The participation
rate is usually less than 100%. For example, if the S&P 500
increases by 10% and the participation rate is 80%, the indexed
annuity would be credited with 8%. The insurance company may
have the right to change the participation rate from year to year
or when the annuity is renewed for a new term.
Margin/Spread/Administrative Fee
Some indexed annuities subtract a specific percentage from the
calculated change in the index before crediting interest to the
contract. This "margin," "spread" or "administrative fee," which
may be charged instead of, or in addition to, a participation rate,
is subtracted only if the change in the index produces a positive
interest rate.
Index Term
This is the period over which index-linked interest is calculated
and/or the length of time during which withdrawals or surrenders
are subject to a charge.
Cap Rate
Some indexed annuities put a cap or maximum on the indexlinked
interest that will be credited to the annuity. For example, if
the market index increases 20% and the annuity has a 15% cap
rate, only 15% will be credited to the annuity. Not all annuities
have a cap rate.
Floor
This is the minimum guaranteed interest that will be credited to
the annuity. This guarantee is based on the claims-paying ability
of the issuing insurance company.
Averaging
Some indexed annuities use an average of the changes in the
index's value rather than the actual value of the index on a
specified date.
Interest Compounding
Some indexed annuities pay simple interest during the index term,
while others pay compound interest, meaning that index-linked
interest that has already been credited to the contract during the
term also earns interest in the future.
Exclusion of Dividends
In measuring index gains, most indexed annuities count only
equity index gains from market price changes and exclude any
gains from dividends.
Vesting
In some indexed annuities, none or only part of the index-linked
interest is credited to the contract if the annuity is surrendered
before the end of the term.
The combination of these policy features found in any particular indexed annuity will
make a difference in the amount of money your annuity investment will earn and in
the amount of money you will receive if you surrender the annuity early. As a result,
before you purchase an indexed annuity, it is important that you fully understand the
various features in the contract you are considering.
Each indexing method generally contains preset combinations of features, which
impact the potential growth of your annuity investment.
Annual Reset (or Rachet)
Index-linked interest is determined each year by
comparing the index value at the end of the contract
year with the index value at the start of the contract
year. Interest is added to your annuity each year
during the term. Any declines are ignored.
Advantages
Future decreases in the index will not affect interest
already earned.
May credit more interest than other indexing methods
when the index fluctuates up and down often during the
term.
Any gain is locked in each
year.
Disadvantages
May be combined with other
features, such as averaging
and lower cap rates, that
work to limit the amount of
interest credited each year.
The participation rate may
change each year and
generally be lower than that
of other indexing methods.
High Water Mark
Looks at the index value
at various points during
the term, usually annual
anniversaries. Interest is
then based on the
difference between the
highest index value and
the index value at the
start of the term. Interest
is credited at the end of
the term.
Advantages
May credit higher interest
than other indexing methods if the index reaches a high
point early or in the middle of the term and then drops
off at the end of the term.
Provides some protection
against declines in the index.
Disadvantages
Since interest is not credited
until the end of the term, index-linked interest may not
be paid if the annuity is surrendered before the end
of the term.
May be combined with other
features, such as lower cap and participation rates, that
limit the amount of interest earned.
Point-to-Point
Compares the change in the index at two distinct
times, such as the beginning and ending
dates of the contract term.
Advantages
May be combined with other
features, such as a higher
cap rate or higher
participation rate, which
may result in a higher rate
of interest being credited.
Disadvantages
Relies on a single point in
time to determine interest,
meaning that an earlier gain
can be lost if the index
decreases dramatically at or
near the end of the term.
Since interest is not credited
until the end of the term,
index-linked interest may not
be paid if the annuity is
surrendered before the end
of the term.
When you are ready to begin receiving income from an indexed annuity, you can
select from a variety of options, including:
Lump Sum Distribution
You can surrender your indexed annuity and receive the entire
value in a lump sum payment. This option requires that income
tax be paid on the indexed annuity earnings in the year you
receive them. In addition, a lump sum distribution does not solve
the problem of outliving your retirement income.
Systematic Withdrawals
You can set up a systematic withdrawal plan, through which you
receive a specified amount of money at regular intervals, such as
$1,000 per month, until all assets have been withdrawn. With this
option, you have the flexibility to change the payment schedule in
the future. Since, for income tax purposes, earnings are
considered withdrawn before principal, the likelihood is that the
earlier withdrawals will be fully taxed at ordinary income tax rates.
In addition, with this option there is no guarantee that you will not
outlive your retirement income.
NOTE: A lump sum distribution or systematic withdrawals made prior to
age 59-1/2 may be subject to a 10% federal tax penalty on the
taxable amount of earnings withdrawn, unless one of the
exceptions is met.
Annuitization
You convert the value of your indexed annuity into a lifetime
income or into a stream of payments for a fixed period of time.
As reviewed on page 10, there are a variety of annuity income
options from which to select.
Other Options
Talk to your licensed financial adviser about other options that
may be available in the indexed annuity contract you are
considering.
Does it sound like a Fixed Indexed Annuity might be right for you?