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Pros and Cons of Indexed Annuities

Annuities are a popular option for people planning for retirement, but there are many different types of annuities that you can choose from. One popular option is an indexed annuity, a hybrid type of annuity that tracks a stock market index such as the S&P 500 or the Dow Jones Industrial Average. Indexed annuities have some real upside, but they are not without risk. Like any financial product, there are pros and cons to consider before buying an indexed annuity. If you want help figuring out how an indexed annuity might fit into your retirement plan, consider working with a financial advisor.

What Is an Indexed Annuity?

An indexed annuity is a hybrid annuity type. In other words, they take features from both fixed and variable annuities, with some extra added protections.

Variable annuities are annuities where your payout is determined based on the performance of the investments made with the money you pay into the annuity. This is different from a fixed annuity, where the payout is predetermined by rates set by the annuity provider. A variable annuity has the potential for higher payouts when the annuity period arrives, but there’s also higher risk. More specifically, a poor performance could result in lower payments than you’re expecting. On the other hand, fixed annuities often have minimum rates, with rates varying from 1% to 3% a year.

An indexed annuity works like a variable annuity in that you choose investments that track one of several market indices. A market index is a grouping of companies designed to show the overall performance of the market or a segment of it. Some of the more well-known indices are the S&P 500 and the Dow Jones Industrial Average. There are also indices that track specific segments of the market such as tech, healthcare or energy.

But where indexed annuities intersect with fixed annuities are when you consider alternate return potential within them. Most annuity providers provide a “fixed account” alongside the indices that you can also put your money in. These accounts work just like fixed annuities, as they have fixed rates and minimums.

There are many other indexed products available for investing such as indexed mutual funds and indexed exchange traded funds (ETFs). Indexed annuities take these same principles and apply them to annuities, which provide a consistent income stream latrine life, making them favored products for retirement planners.

The Pros of Indexed Annuities

Pros and Cons of Indexed Annuities

There are many pros to using an indexed annuity as part of our retirement plan. First, there are the pros that come with any annuity – you get a consistent stream of income in your later years, which is helpful for retirement planning. In fact, a recent study shows that using annuitized products often helps retirees feel more comfortable spending their money, as the psychological benefit of seeing money come into your account each month makes spending seem more permissible.

Indexed annuities also have some pros over other annuities. For instance, you might be interested in a variable annuity because you have the potential for greater growth than the set income provided from a fixed annuity. With an indexed annuity, you still get that, but with a layer of security provided by the index. Indexed annuities follow the market, so there is a better chance of seeing steady gains than in variable annuities where investments are chosen by a manager, which has greater potential for failure.

Indexed annuities also generally have higher rates of return than certificates of deposit (CDs), which are another popular retirement planning product.

The Cons of Indexed Annuities

There are some things to look out for with indexed annuities, though. For one, indexed annuities are highly diversified due to their following of an index. This means that the potential for any really large gains is muted. This is a classic investing risk-reward paradigm. The risk with indexing is lower than with other investments, but as a result the potential returns are lower.

Indexed annuities also often have high sales commissions. This is something to consider when purchasing any product. Fees can sometimes be murky in the financial planning industry, so make sure you do your homework and know exactly what you are paying and what you’re getting for it before you commit to a indexed annuity or any other product.

It’s also worth noting that some indexed annuities have an interest rate cap, meaning you don’t get the full value of your gain. Again, just make sure you know the terms of your annuity contract before you decide to make it a part of your plan.

Bottom Line

Pros and Cons of Indexed Annuities

Indexed annuities are an insurance product that can be a productive part of a retirement plan. They provide an income stream later in life in exchange for premium payments now. The returns are based on the performance of how the investments do. Unlike other variable annuities, indexed annuities track a stock market index. So the performance of the market as a whole (or a market sector) will be reflected in the annuity.

Be sure to diversify your retirement plan regardless of if you have an indexed annuity or not. Keep your assets in multiple types of accounts, such as 401(k), traditional and Roth IRAs and more. By doing this, you’ll protect your money for when you need it most: retirement.

Retirement Planning Tips

  • For help with indexed annuities or any other retirement questions, consider working with a financial advisor. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • Life insurance is another important product to consider, especially if you have minor children. To see how much life insurance you should buy, use SmartAsset’s life insurance calculator.

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Ben Geier, CEPF® Ben Geier is an experienced financial writer currently serving as a retirement and investing expert at SmartAsset. His work has appeared on Fortune, Mic.com and CNNMoney. Ben is a graduate of Northwestern University and a part-time student at the City University of New York Graduate Center. He is a member of the Society for Advancing Business Editing and Writing and a Certified Educator in Personal Finance (CEPF®). When he isn’t helping people understand their finances, Ben likes watching hockey, listening to music and experimenting in the kitchen. Originally from Alexandria, VA, he now lives in Brooklyn with his wife.
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