Deferred annuities appeal to conservative investors who want to convert a lump sum into an income stream. Fixed deferred annuities pay a set rate of interest and are not subject to principal fluctuation. However, when you limit your risk, you often limit your growth potential. Indexed annuities are hybrid products that provide the same kind of principal guarantees as fixed annuities while providing you with the opportunity for growth.
You buy a single premium deferred annuity with a lump sum of money. You cannot bolster the contract by making additional premium payments. The contract consists of two phases: the accumulation stage and the income phase. The accumulation stage usually lasts between four and 20 years. During this phase, your premium is invested in a subaccount. At the end of the accumulation phase, your insurer converts your lump sum into an income stream. This conversion process is known as annuitization. Thereafter, you receive monthly income payments for a set number of years or for life.
The returns on an indexed annuity are based on movements in market indexes such as the Standard and Poor's 500 Composite Stock Price Index. If the index rises, your contract grows in value. If the index drops, your annuity loses value. Some insurance firms adjust your contract value annually, while others base your returns on the value of the index when your contract matures. You may miss out on market highs and lows, because your returns are based on the market value on particular dates rather than a moving average.
If you invest directly in the stock market, you enjoy the full benefit of market upturns. With an indexed annuity, your returns are capped by the participation rate. If your contract has a 50 percent participation rate, this means your earnings are capped at 50 percent of the gains made by the index. Other insurers cap your gains by assessing an asset or margin fee. The fee is the percentage of your gains that the insurance company withholds. If your contract includes an asset or margin fee of 5 percent, when the index rises by 15 percent, you only get access to 10 percent of those gains.
In a down market, your contract may lose value, but your returns are not based upon the market index. Instead, your returns are based on a minimum rate guarantee. This figure represents the amount of interest the annuity provider must credit to your contract in the event of a market downturn. However, you only earn interest on a portion of your purchase premium. Generally, you get back 80 or 90 percent of your original investment. The interest is then applied to that sum of money rather than your entire purchase premium. Therefore, even with the additional interest you may end up with less than you originally invested.
Deferred indexed annuity contracts usually include hefty surrender penalties. You pay these fees if you make withdrawals during the accumulation stage. Fees vary between insurers, but surrender fees can top 20 percent of your contract value. In addition to surrender fees, you also have to contend with taxes. Annuities grow on a tax-deferred basis, which means your withdrawals are subject to state and federal income tax. If you make a withdrawal before reaching the age of 59 1/2, you typically have to pay a 10 percent tax penalty in addition to regular income tax on the withdrawal.
- Comstock/Comstock/Getty Images