Equity indexed annuities are insurance contracts that are structured to provide you with a monthly income stream. Your income payments may rise as a result of a stock market upturn but the contract also includes protections that safeguard your cash during market downturns. However, equity indexed annuities also include downsides that include fees and limitations on your returns.
When you buy an indexed annuity the contract issuer invests your purchase premium in an investment account that tracks a major market index such as the Standard and Poor's 500. Your contract increases in value any time the index rises. You benefit from rising stock prices without having to invest your cash directly in individual stocks. However, you do not enjoy the full benefit of market upswings because your returns are capped. Annuity contracts include a participation rate, and this rate limits your returns. If your contract includes an 80 percent participation rate, your returns are capped at 80 percent of the actual market gains. In contrast, if you invest directly in the stocks that are listed in the index, you realize 100 percent of the gains.
Minimum Return Guarantees
Market indexes do not always rise, and your contract could lose value during a market downturn. However, indexed annuity contracts include minimum rate guarantees that assure you of a minimum rate of return even if the index performs poorly. Minimum rate guarantees provide you with a measure of principal protection that you would not have if you invested directly in stocks. On the downside, you typically get back only a portion of your original investment and then you earn interest on that sum. In many instances, you get back just 80 or 90 percent of your premium and then interest is paid on that cash. Consequently, you may end up with less than you originally invested.
Annuities grow tax-deferred, and you can buy these contracts with either pre-tax retirement money or with already-taxed funds. You do have to pay ordinary income tax when you make withdrawals, but over the course of your contract your money compounds and grows more quickly than it would inside a taxable investment. However, you have to pay a 10 percent federal tax penalty if you withdraw cash from an annuity contract before you reach age 59 1/2.
Indexed annuities work similarly to traditional pension plans with contract terms often lasting for 10 or 20 years. You do not have to actively manage your contract and you avoid the kind of principal risks that are associated with 401(k)s and other stock- and mutual fund-related investments. On the downside, equity annuities are illiquid because withdrawals before the end of the contract term are subject to surrender penalties. Fees vary but often top 20 percent of the actual contract value. You pay these fees in addition to any applicable taxes and tax penalties.