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Indexed Annuities Pros and Cons

By: Royce Gould
For : AnnuitiesProsAndCons.Org
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Date Added : April 9, 2011 Views : 163
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Few products generate as much confusion and controversy as indexed annuities, both pro and con. Indexed annuities have made major strides in recent years however and are well worth considering.

The premise of an indexed annuity is attractive- it is promoted as a high yield safe investment. Fundamentally, an indexed annuity is much like a fixed annuity- in fact, they are often called fixed indexed annuities in the press. As with a fixed annuity, the insurance company purchases secure bonds with the premium paid in, but unlike a fixed annuity, the interest income is invested in equity market options. Hence, another common term for the same product- equity indexed annuity.

Why an option? An option gives the holder exposure to market appreciation without downside risk- the cost of the option is the only at-risk portion. In reality, these are very safe investments with upside potential.

The upside potential however is where confusion sets in. The indexed annuity return is calculated differently by each company, and is subject to insurance costs, dividend exclusions, surrender charges, maximum gain caps, participation rates, and a host of other measures. These are all driven by a few underlying fundamentals.

1) You are buying insurance and a guaranteed return of principal. You are shifting risk to the insurance company, and therefore there is a component of cost for this insurance.

2) Unlike many other annuities where the appreciate rate is guaranteed, an indexed annuity appreciation rate goes up with the market, but is governed or limited by how much market participation the earnings from you underlying portfolio can purchase. Hence the participation rate or cap rate.

3) Unlike variable annuities however, an indexed annuity is far less likely (we cant say never) to go down in value. Because your principal is not at risk as it is with a variable annuity, your overall safety quotient is far higher.

There are many benefits to using this approach, and in fact, it is not dissimilar to many hedge or equity funds- they are simply using market instruments to mitigate risk and participate in upside. The benefit of doing so in an annuity however is that you are joining forces with an established insurance company and can therefore rest easy that they are assuming and shouldering risk and making you contractual guarantees. And unlike Social security or pensions, these guarantees are actually backed by reserves and real value!
Some of the contract provisions to be wary of with Indexed Annuities are:

Long surrender charges, possibly even charges that survive the life of the annuity holder and are assessed to the heirs.

From some companies, indexed annuities are only offered as two-tiered products which force the holder to annuitize their account balance to get even the guaranteed minimum rate. In other words, the guarantees and floor returns are only valid if you convert your equity indexed annuity at the end of the deferral period into an annuity payment stream, otherwise you're only entitled to your paid in premiums with 0% gains.

Dividend exclusion: Many companies remove dividends from their calculation of the index return. Excluding dividends takes 2-4% off the equity index annually.

Timing- when index returns are calculated can have a dramatic effect on the return.

Surrender fees as high as 10%.

Surrender schedules 12 years or more.

Compared to variable annuities, indexed annuities are far safer, and often have much lower administrative costs. Its imperative, however to have unbiased and knowledgeable advice when selecting such a product. Get some straight talk on annuities before you commit or consider a particular product, and be sure you know what you need before diving into the minutiae of a contract.

Consider also Fixed annuities. Fixed annuities are not as glamorous or in favor, but they are simpler than equity index annuities, their returns are much safer, and their risks much lower. Why aren't they promoted as often? Unfortunately in todays low rate environment they are not as competitive.

There certainly are some good equity index annuity contracts out there, be sure to do your homework prior to investigating a particular product.




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