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Understanding Indexed Annuities

There’s a reason that annuities are appealing financial products. They take the uncertainty out of retirement income by guaranteeing an annual sum. But do the costs outweigh the benefits? Let’s take a closer look at indexed annuities and what experts say about them.

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Indexed Annuity Basics

An annuity is an agreement between you and the institution that sells you the annuity (generally an insurance company). The terms of the agreement state the amount of money you’ll receive each year. They also detail the costs and fees you’ll pay to the insurance company.

Wondering what happens to the lump sum you give the insurance company? Well, if you buy an indexed annuity that money is invested and grows over the years you receive your annuity.

As a result, indexed annuities often go by the name “equity-indexed annuities” because they’re indexed to equities. Equities, in case you need a refresher, are stocks that trade on the stock market.

Pros and Cons of Indexed Annuities

Understanding Indexed Annuities

Insurance companies often pitch indexed annuities as a great opportunity to earn returns on the money you’ve saved for retirement. The insurance company will take your money and invest it in an index fund that tracks the S&P 500. But what are the pros and cons of this strategy?

For one thing, the returns you’ll earn on an equity-indexed annuity aren’t comparable to the returns you’d get if you invested the same lump sum in a low-fee index fund that also tracked the stock market. Why? Because insurance companies deduct fees and, in some cases, cap your earnings.

In a good year, the stock market will make gains. However, depending on the terms of your indexed annuity your money might not grow by the same percentage that the stock market adds. You could see only 80% of the stock market gains, depending on the participation rate of your indexed annuity. The participation rate is the percentage of stock market gains you’ll earn. If your gains will match the gains of the index, your participation rate is 100%.

Some indexed annuity come with a rate cap. If you have an indexed annuity with a rate cap, you won’t be able to earn yields above that cap, no matter how well the stock market performs in a given year.

On the flip side, indexed annuities, unlike a regular pot of money invested in an index fund, don’t lose value during a market downturn. Your insurance company might set terms that say you won’t earn any returns if the stock market falls, but the insurance company won’t take money out of your annuity funds. Some insurance companies will pay out a yield of, say, 2% in the event of a downturn, which will help take the sting out of inflation.

Bottom Line

Understanding Indexed Annuities

If your financial advisor recommends that you purchase an indexed annuity it’s worth doing plenty of research before you make your decision. Does your advisor have a fiduciary duty to put your interests first? If not, he or she might be recommending the indexed annuity to get a kickback or commission, not because it’s the best fit for your retirement. Like other annuities, indexed annuities offer a trade-off between security and cost. It’s important to understand those trade-offs before you put your retirement savings on the line.

Photo credit: ©iStock.com/da-kuk, ©iStock.com/mediaphotos, ©iStock.com/adamkaz

Amelia Josephson Amelia Josephson is a writer passionate about covering financial literacy topics. Her areas of expertise include retirement and home buying. Amelia's work has appeared across the web, including on AOL, CBS News and The Simple Dollar. She holds degrees from Columbia and Oxford. Originally from Alaska, Amelia now calls Brooklyn home.
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