Could an Indexed Annuity be right for you?

What is an indexed annuity?

An indexed annuity is a contract issued and guaranteed¹ by an insurance company. You invest an amount of money (premium) in return for protection against down markets; the potential for some investment growth, linked to an index (e.g., the S&P 500^® Index); and, in some cases, a guaranteed level of lifetime income through optional riders.

How is the return calculated?

One element of indexed annuities that is often misunderstood is the calculation of the investment return. To determine how the insurance company calculates the return, it is important to understand how the index is tracked, as well as how much of the index return is credited to you.

Index tracking. The amount credited to your account depends, in part, on how much the index changes. Insurance companies use various methods to track changes in the index value. For example, they may use different time periods, such as a month, a year, or even longer periods of time. It is important to understand how the index is tracked, as it will have a direct impact on the return credited to you.

The amount an insurance company credits to you depends on a variety of factors (any of which can potentially be combined), such as:

• Cap, which is an upper limit put on the return over a certain time period. For example, if the index returned 10% but the annuity had a cap of 3%, you receive only a maximum 3% rate of return. Many indexed annuities put a cap on the return.
• Participation rate, which is the percentage of the index’s return the insurance company credits to the annuity. For example, if the market went up 8% and the annuity’s participation rate was 80%, a 6.4% return (80% of the gain) would be credited. Most indexed annuities that have a participation rate also have a cap, which in this example would limit the credited return to 3% instead of 6.4%.
• Spread/margin/asset fee, which is a percentage fee that may be subtracted from the gain in the index linked to the annuity. For example, if an index gained 12% and the spread fee was 4%, then the gain credited to the annuity would be 8%.
• Bonus, which is a percentage of the first-year premiums received that is added to the contract value. Typically, the bonus amount plus any earnings on the bonus are subject to a vesting schedule that may be longer than the surrender charge period schedule.^{2, 3} Given the typical vesting schedule, the bonus may be entirely forfeited upon surrender in the first few contract years.
• Riders, which are extra features, such as minimum lifetime guaranteed income, that can be added to the annuity for additional costs, further reducing the return.

“One challenge here is that insurance companies typically have the flexibility to lower the participation rate, increase the spread, or lower the cap, which lowers your potential returns,” says Tom Ewanich, a vice president and actuary at Fidelity Investments Life Insurance Company. “If this happens during the surrender charge period after you’ve invested in the annuity, you have very little recourse.”

In addition, an often overlooked point is that for the purposes of the insurance company calculation, an index return excludes dividends, so your return from an indexed annuity will also exclude dividend income. This is important because history indicates that dividends have been a strong component of equity returns over the course of time. Since 1930, dividends have made up approximately 40% of the S&P 500’s average annual total return.⁴

How does a cap impact potential returns?

Let’s consider the following chart, which uses a representative indexed annuity with a monthly cap of 1.50% on upside returns.

Over the 10 years ending December 31, 2016, the S&P 500 average annual return was 6.95% (4.67% without dividends), while the indexed annuity returned only 2.31% annually—despite an 8% initial bonus and guaranteed annual floor of 0%.