An indexed annuity is an investment product that provides a flow of payments to a buyer in return for a lump sum or series of lump sum payments. The flow of payments for an indexed annuity has a variable payment based on the performance of an underlying index. Most indexed annuities are linked to the performance of an underlying equity index such as the S&P 500. Like all investment products, indexed annuities have pros and cons that should be understood before buying.
Indexed annuities contain a potential for a higher return than a fixed annuity because the annuity holder shares in the return of the underlying index. If the underlying index has a strong performance, the annuity holder will share in that performance to the extent permitted by the annuity contract. The share of the index performance that is received by the annuity holder is called the participation rate, and can range from 50 percent to 90 percent of the return of the index.
Guaranteed Minimum Return
Indexed annuities have a minimum rate of return that is guaranteed to the buyer. This is usually 3 percent a year but is sometimes based on only 90 percent of the cost of the annuity, so an annuity holder can have a negative annual return. However, a buyer is protected from a substantial decline in the stock market.
Since indexed annuities are such a popular investment, there are many different insurance companies that offer them to customers. The large supply of offerings will lead to more competition and better deals for buyers.
An indexed annuity represents a contract between an individual and the insurance company, and this contract is subject to the credit risk of that insurance company. If the insurance company becomes insolvent or is liquidated, the buyer would have to seek redress in the court system. Several nationally recognized ratings agencies maintain ratings of public and private insurance companies that an investor can use to monitor an insurer's financial strength.
An investor who wants to withdraw funds from his indexed annuity contract early faces a surrender charge, which is a fee imposed by the insurance company to compensate it for returning the money early. Surrender charges can be a percentage of the amount withdrawn or a reduction in the interest rate credited to the annuity.
Indexed annuities have substantial fees built into the contract, and not all these fees are transparent to a buyer. Although the insurance company pays commissions to brokers who sell indexed annuities, these commissions are ultimately paid by the consumer, since the insurer structures the annuity taking the commissions into account as a cost.
Insurers also have hidden fees in the products. The percentage of the return not given to investors should be considered a fee as well. Some insurers also charge an asset management fee to manage the collective amount of annuity funds received.