What is an 'Indexed Annuity'

An indexed annuity is a special class of annuities that yields returns on contributions based on a specified equity-based index. These annuities can be purchased from an insurance company, and similar to other types of annuities, the terms and conditions associated with payouts depend on what is stated in the original annuity contract.

BREAKING DOWN 'Indexed Annuity'

Indexed annuities offer annuitants the opportunity to earn higher yields based on stock market performance with protection against market declines. However, it is also common for an annuitant's yields to be somewhat lower than expected due to the combination of caps on the maximum amount of interest earned and fee-related deductions. The real challenge is in understanding how an indexed annuity works as it is much more complex than a standard fixed annuity.

Indexed Annuities and Stock Market-Based Yields

The rate on an indexed annuity is calculated as a percentage of the gain in the Standard & Poor’s 500 Index. The actual percentage applied to the credit rate is based on the year-over-year (YOY) gain in the index or the average monthly gain over a 12-month period.

In a year when the stock index realizes a gain, a portion of the gain is credited to the account based on a participation rate dictated by the life insurer. The participation rate can be as high as 100%, meaning the account is credited with all of the gain, or it can be as low as 25%. Most products offer a participation rate in the range of 80 to 90% at least in the early years of the contract. For example, if the stock index gained 15%, an 80% participation rate translates to a credited yield of 12%. Most products offer a high participation rate in the first year or two, but the rate is then adjusted downward.

Indexed Annuities and a Yield or Rate Cap

Most indexed annuity contracts include a yield or rate cap that can further limit the amount credited to the accumulation account. For example, a 7% rate cap limits the credited yield to 7% no matter how big the stock index gain. Rate caps can range from a high of 15% to as low as 4%, and are subject to change.

In years when the stock index declines, the account is credited with a minimum rate of return. A typical minimum rate guarantee is about 2%. Some can be as low as 0% and as high as 3%.

At specific time intervals, the insurer adjusts the basis of the account upward to include the gain in value that occurred in that timeframe. The principal, which is guaranteed by the insurer, never declines in value unless a withdrawal is taken, and the amount guaranteed to the beneficiaries increases over time. There are several different methods used to adjust the basis, such as a YOY reset or a point-to-point reset, which incorporates two or more years' worth of returns.

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