An indexed annuity is a financial product that pays out a return based on the performance of a linked index. The contract is backed by an insurance company and is popular among retirees because it provides a relatively steady stream of income with downside risk protection. However, it also severely limits the upside potential of the investment, illustrating the tradeoff between risk and return.
An indexed annuity is a financial product that pays out an income stream based on the performance of the linked index (i.e., S&P 500).
Indexed annuities provide downside protection through their minimum guaranteed return. However, they also limit potential upside through the participation rate and rate cap.
The guarantees of the annuity contract rest on the ability of the insurance company to honor them.
Indexed Annuity Components
1. Participation Rate
The participation rate refers to the percentage of index return that is credited to the annuitant (annuity holder). For example, if the indexed annuity offers a participation rate of 90% and the linked index realizes a return of 10% for the period, the annuitant receives 9% (90% x 10% = 9%). Most indexed annuities offer a participation rate between 80%-90%.
2. Rate Cap
The rate cap also limits the upside of the index by establishing a ceiling on the rate. For example, if the indexed annuity comes with a rate cap of 7%, the annuitant will get a maximum return of 7%, regardless of the amount of the index’s earnings. When the participation rate is used together with the rate cap, the annuity return is the minimum between the two.
3. Spread/Margin/Asset Fee
Depending on the insurance company, a fee may be applied to the return rate. For example, if the fee is 2% and the index return is 7%, the annuitant receives 5% (7% – 2%).
4. Minimum Guaranteed Return
In contrast with the rate cap, the minimum guaranteed return is offered as a floor to limit the downside of the index. For example, the insurance company may guarantee a minimum return of 2%, so the annuitant is promised 2% even if the index performs poorly over the period.
A rider is an optional form of benefit that can be purchased to supplement an indexed annuity. Many different types of riders can be used to accommodate financial needs, such as early fund withdrawal, lifetime income, death benefits to beneficiaries, and many others at the expense of reduced returns.
Indexed Annuity Examples
An annuitant buys an indexed annuity linked to the S&P 500 Index. The terms of the indexed annuity are 80% participation rate, 7% cap rate, and a minimum guaranteed return of 2%.
If the S&P 500 generates a 15% return:
Participation rate = 15% * 0.8 = 12%
Minimum of participation rate and cap rate = 12% > 7% = 7% return
If the S&P 500 generates a 6% return:
Participation rate = 6% * 0.8 = 4.8%
Minimum of participation rate and cap rate = 4.8% < 7% = 4.8% return
If the S&P 500 generates a -9% return:
Minimum guaranteed return: 2% return
Advantages of Indexed Annuities
Increase in returns when the underlying index performs well
Downside risk protection from the minimum guaranteed return – Protects the principal amount
Deferred taxes – Taxes are realized only when funds are withdrawn, so it can be advantageous for managing tax payments
Disadvantages of Indexed Annuities
No dividends – Annuitants miss out on dividend payouts, which historically returns an average of 1.87% on the S&P 500.
Limited upside from participation rate and rate cap
Tax withdrawal penalty – Contrary to the acclaimed advantage that annuitants can’t lose money on the principal because of the downside risk protection, it is actually possible to incur losses if the annuitant withdraws funds early or surrenders the annuity. Also, if the annuitant withdraws funds before age 59½, they face a tax withdrawal penalty.
Surrender period – Annuities lack liquidity because annuitants cannot touch their money during the surrender period, which is typically 6-8 years. If they surrender the annuity contract during this period, they are charged a high surrender fee.
Insurance company’s financial health – Annuity payments are tied to the financial health of the insurance company; if the company goes bankrupt, the indexed annuity is worthless.
CFI offers the Capital Markets & Securities Analyst (CMSA)® certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
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