Index Annuity Guide

Index Annuity Guide

Welcome to the index annuity guide. The index annuity is one of the most versatile and timely investment options available today.

First, lets define an index annuity. The index annuity, also known as a fixed index annuity, or equity index annuity is a fixed annuity contract between a life insurance company and the policy owner which provides savings for retirement while providing the benefit of tax deferred growth. Also, the growth of the annuity is linked to an external equity or bond reference such as the Standard and Poors 500 Composite Index. However, the annuity is an insurance contract and the policyowner is not buying shares of any stock,  fund or index.

Now, let’s talk about one of the most important benefits of the index annuity. The ability of the contract owner to make stock market like returns when the stock market rises but never lose a penny when the stock market declines. Imagine going to Las Vegas and playing blackjack. Each time you won you got to keep your winnings but each time you lost, you got your money back.  For this benefit alone, almost every retirement plan should include an index annuity as a component of the overall plan.

Another important benefit  is the bonus. Some  insurance companies pay as much as 8-10% bonus on the initial amount invested. For example, a $10,000 initial premium with a 10% bonus immediately becomes $11,000.  If the account had 8% equity index gains the first year, the account would be worth $11,880 after the first year, a gain of 18.8%. Plus, the account value could never go below $11,880 unless withdrawals were made. That is why the index annuity is usually an excellent investment option for a risk averse investor.

Tax deferral is another important benefit of the index annuity. All earnings are tax deferred until withdrawn. Then only a portion of each payment is taxable because part of the payment is a return of premium. This could result in lower taxes if the owner is in a lower tax bracket during retirement. That may not always be the case, so proper tax planning is necessary when making withdrawals from an annuity or any tax advantaged investment such as an IRA or 401K.

Traditional savings plans such as CDs, money markets, mutual funds, and savings accounts are taxed every year.  By postponing taxes with the index annuity, the money will compound faster because interest is earned on the money that would have been paid in taxes.

Annuities are not life insurance, even though they are sold by life insurance agents and issued by life insurance companies. The Internal Revenue Service considers all annuities to be retirement plans so they are subject to the early withdrawal penalties if withdrawn before age 59 1/2.  An index annuity may be used to fund a qualified retirement plan even though they are not considered qualified for tax purposes.

Whereas life insurance is designed to create  an estate which is paid at the death of the owner, annuities are designed to liquidate an estate over a period of time by making payments to the annuitant for a specified time period or to the beneficiary in the event of the death of the annuitant.  This solves one of aging American’s greatest fears- running out of money.

The index annuity offers the potential for higher returns than the normal fixed annuity which pays a specified rate of interest each year. However, in years when the stock market is down the return on some index annuities is zero. This is much better than losing money which happens in most retirement accounts.

In summary, the index annuity can become a vital part of any retirement planning strategy because of its potential for high gains and no losses and attractive bonuses. In our next post in the index annuity guide, we will cover the working parts of the index annuity.

Index Annuity Guide- Moving Parts

Index Annuity Guide

The index annuity has several moving parts which can have an effect on the return. It is important for the owner to understand these parts, how they move and the effect they can have on an annuity. The moving parts consists of caps, asset fees,  participation rates and methods of interest crediting.

1. Caps

The cap is an upper limit that will be credited to the policy. The cap may be the only moving part in some annuities. Sometimes it is used in conjunction with a participation rate.  For example, if a policy earns 14% but has a 10% cap, only 10% will be credited to the account.

2. Asset Fees

The asset fee also known as the margin spread is used to subtract a contractual percentage from the change in the index. If the index has a gain of 14% and the contract has a 2% asset fee, the amount credited  would be 12%.  The asset fee is used only if the index gain is larger than the asset fees. Most life insurance companies do not use asset fees in their contracts.

3. Participation Rates

The participation rate in the index annuity is a percentage rate as stated in the contract multiplied by the index gain. The rate is guaranteed in most contracts and always has a guaranteed minimum rate.  The participation rate can be moved up or down by the insurance company usually only on each contract anniversary. If a policy has an index  gain of 20% and a 75% participation  rate, 15% will be credited to the interest account.

4. Methods of Interest Crediting

The amount of interest credited depends on the index term which is usually one year but can be as long as ten years. Some companies only pay simple interest during the indexing term while other life insurance companies allow interest compounding during the index term which allows already credited interest to earn interest in the current term and future index terms.  If the policy is surrendered before the end of a term , some companies will not credit any interest earned for that term. Other companies  credit the amount that is vested. As the policy nears the end of a term, the vested amount increase until it is 100% at the end of the term.

The moving parts of the index annuity reflect the actual costs incurred by the company and are used to maintain profitability and credit ratings. So it is absolutely imperative for a prospective purchaser to understand what moving parts are and their corresponding percentages in order to make an informed purchasing decision. The agent should explain the policy, show the percentages used in the policy and answer any questions. The index annuity sounds complicated but compared to other investments it is reasonably easy to understand.

Annuities are long term investments and they offer limited liquidity without surrender charges, so the owner should have an accurate understanding of their future liquidity needs. As an integral part of any retirement program, annuities offer very low risk and usually offer higher returns than CDs or money market funds. The next post will analyze how the annuity works and different indexing methods.

Equity Indexed Annuity-Best Investment Around?

Equity Indexed annuity- best investment around?

Is the equity indexed annuity the best investment in today’s economic environment? Let’s analyze the most important investment attributes.

Yield: Most equity indexed annuities pay a bonus of 6-10% on the initial amount invested. After that, the returns are tied to the performance of an index like the S&P 500 or the Dow Jones Industrial Average. In years where the indexes perform well, the annuity can perform very well. In years where the averages go down, the annuity will return zero instead of losing money like stock mutual funds. Also, the annuity has a fixed interest rate component which usually pays 3-4% which is substantially higher than CDs and money market funds.

Safety: The equity indexed annuity is guaranteed by the full faith and claims paying ability of the issuing life insurance company. It is important to select a company with a high rating and in many cases these companies will be backed by billions of dollars of assets and reserves from a company that may be over 100 years old. Life insurance companies are analyzed by four rating agencies and each agency assigns a letter rating to the company. The review includes a review of the company’s balance sheet, operating performance and business profile. It is important to choose a company with A, A+ or A++ rating as these are the safest companies. Each state has an insurance commissioner that regulates insurance companies and monitors their financial performance. When an investment is made in an equity indexed annuity, the life insurance company is required by law to set aside a minimum of $1.04 for every $1 of principal that is invested. Many companies have a $1.50 to $1 ratio of reserves to deposits. By contrast a bank is only required to have between 5-15% of a deposit in reserve. Insurance companies control more assets than the banks and oil companies in the world combined. They have very conservative investment strategies which help keep them safe and liquid.

Taxes: Taxes on an equity indexed annuity are not paid until a withdrawal is made. This allows the premium and interest to grow tax deferred. This gives you triple compounding because you earn interest on the principal, interest on your interest, and interest on the money that would normally be paid in taxes. Also, the owner controls when the taxes will be paid by advantageous timing of their withdrawals. Another important tax factor is the exclusion ratio. When an annuity is annuitized, part of the monthly payment is considered a return of principal and is not taxable.

This keeps a substantial portion of your monthly payment off your tax return because only a portion of your payment is taxable interest. This lowers your overall income in computing taxes on social security benefits.

Liquidity: Equity indexed annuities are intended to be long term investments. They usually have decreasing surrender charges of 10% or more that may run as long as 10 to 14 years. However, most programs allow a 10% withdrawal on an annual basis with no penalties. These surrender charges have a positive effect on insurance company safety because it is unlikely there would a run on the company because of the charges that would be incurred to withdraw the money.

Fees: When money is invested in an equity indexed annuity, the whole amount is immediately credited and there are no sales charges deducted as in other types of investments. There are usually no annual administrative fees and if the policy is held to the end of the surrender period, there are no charges to withdraw the money. Charges are made only if more than 10% is withdrawn in a year or the policy is surrendered before the surrender period is over.

In summary, the equity indexed annuity is close to the perfect investment. It provides safety, growth, tax deferral, low or no fees and limited liquidity. It should be considered for almost every type of retirement plan.