Index Annuity Education

Scott Brooks, MBA, CFP®
5-10 min read

The Facts About Index Annuities

A fixed indexed annuity is a tax-deferred way to grow your savings. They are contracts issued by insurance companies.

Index annuities can be challenging to understand, so I will do my best to simplify them.

Index annuities are for conservative investors who like safety. They were introduced in 1995 to complete with bank CDs. Index annuities are classified as a type of fixed annuity.

Fixed indexed annuities “index annuities” used to be called equity-index annuities until 2006. The name was changed to avoid people thinking the products were equities or stocks. Index annuities are not stocks or equities.

Insurance agents might refer to index annuities as “hybrid” annuities. The term hybrid is misleading because it implies they offer market exposure. They do not.

When I worked for a bank in 1999, I remember sitting through a presentation from Keyport Life. One of their vice-presidents tried to convince us to sell their index annuity.

Everyone at the meeting left confused. So if you are confused you are not alone.  Index annuities can be challenging to understand, so I will do my best to simplify them.

Index annuities are a type of fixed annuity that delivers a fixed income type of return.

They don’t have the upside or downside of the market. They compete with bonds, CDs, MYGA's and other safer investments.

Index annuities allow you to capture some of the growth of a market index while having 100% downside protection. You might have heard insurance agents say,“ Some of the upside, none of the downside.”

Index annuities are linked to a positive performance in an external index.

You are not participating in the market. You are watching the market, and a formula decides how much gain of the index you receive.

How Gains Are Credited

Gains are locked-in every 12 or 24 months at contract anniversary dates.

Once gains are “locked-in” and credited to the account, they will never go away.

Losses in the index will not create losses in the annuity contract.

Some insurance agents say you fall forward, not backward because your statements will go up and not down.

The owner of an index annuity doesn't know how much their annuity will earn every year.

A formula determines how much in gains an investor will receive.

Gains are credited after a period has ended, not before.

You do not get the dividends of the market index. Don’t worry, the insurance company does not keep your money.

Insurance companies invest in safe instruments like US Treasuries. They add call options to get the market upside.

If you want your principal to be guaranteed, index annuities might be for you, especially if you are looking for a slightly higher return than what CDs are paying.

And you don’t need access to the money during the contract term.

You won't lose money in an index annuity due to losses in an index.

Studies show that index annuity returns may be higher than MYGA annuities. Index annuity returns are not guaranteed like MYGAs are.

Newer index annuities offer a wide variety of indexes to choose from.

Two Good Reasons to Choose an Indexed Annuity

1. As a CD alternative, if you don’t mind committing your money to a longer period.

2. As a bond alternative, because index annuities do not have interest rate risk. If rates rise, bonds lose money. This is interest rate risk. Index annuities don’t have this. Bonds do.

Other Reasons to Consider an Indexed Annuity

Tax-Deferred Growth - Index annuities grow tax-deferred. You don't have to pay income taxes on the earnings while the money is growing inside the annuity. You only pay income taxes on the earnings when you withdraw money from your account. Your money grows faster than it would inside a CD because of the triple compounding of interest. This is because you earn growth on the money lost to taxes. This is especially helpful if you are in a higher tax bracket while the money is growing. Tax deferral also means that annuity earnings do not affect your Social Security benefits like CDs and bonds do.

Avoid Probate - Bank CDs and other products go through probate. In some states, probate can be time-consuming and expensive. Indexed annuities pass by beneficiary designation, not probate. Your

named beneficiary can access the funds quickly and easily. There is no need to hire an attorney or pay probate fees.

Flexible Contributions - Most index annuities allow for "flexible contributions." This means you can add money now and add money later. Simply put, you have the flexibility to add money later. This is different from "single premium" annuities, which allow you to only add money once. Most MYGAs are “single premium” and most index annuities are “flexible premium.”

Reasonable Returns - Index annuities an alternative to CDs, MYGAs, and bonds. They may credit higher interest rates.

Creditor Protection - Some states offer creditor protection to assets inside an annuity. Speak with a qualified legal professional for more information.

Capped vs. Uncapped Index Annuities

The two main types of index annuities you will find are caped and uncapped index annuities.

"Capped annuities" index annuities cap the gain you can earn. If your index annuity has a cap, you will never earn more than the cap for any crediting period.  So please be aware of what it is.

"Non-capped" index annuities do not have a cap.

Uncapped annuities might outperform when stock markets generate high returns. Capped annuities are more likely to outperform uncapped products when the stock market is weaker.

Index Annuities vs. Fixed-Rate Annuities

Both index annuities and fixed-rate/MYGA annuities offer tax deferral. Fixed index annuities may credit higher interest rates than traditional fixed annuities.

Funding an Index Annuity

Most index annuities are flexible premium. This means you can add more money over time to your contract.

You can own index annuities in retirement and non-retirement accounts (non-IRA, Roth, traditional IRA, etc.).

You can rollover your funds from a qualified plan (ex. 401(k)) into an annuity set up as an IRA. You can also use an IRA to hold an index annuity.

You can also fund an index annuity with taxable savings from a brokerage account or bank.

Downsides of Index Annuities

1. Insurance companies can change participation rates, annual fees, or both anytime they want. They make the rules and can change them as they see fit.

2. Some index annuities have surrender charges for 15+ years. Several states have banned products with terms of over ten years. We suggest you do the same! I can't think of one good reason to purchase a 16-year product!

3. You do not know what your return will be. If you want a guaranteed return, consider a multiple-year guaranteed annuity (MYGA). You can find the best MYGA rates here or by clicking on our rates tab.

4. Surrender charges apply to early withdrawals.

5. The products can be confusing. It’s difficult to understand how gains are calculated.

6. The commissions are higher on index annuities. The agent you work with makes a larger commission than with MYG’s.

7. Index annuities can be mis-sold, and most advertising is dishonest. Avoid companies that promise you a 7-9% return. Some index annuities offer an income rider. The rider costs 1% every year and will grow your income balance 3-7% per year. If you need "income later," this might not bad, but you don't earn 7%.

8. The returns for most index annuities are similar to MYGA's over the lifetime of the contract. You might earn 1-2% more, but you could also earn less.

Who Buys Fixed Index Annuities?

People who:

1. Like bank CDs

2. Like bonds

3. Earn a high income and prioritize safety

4. Conservative investors with a long time horizon

5. Don’t want the interest rate risk of bonds

6. Want to possibly earn a higher rate than a CD without stock market risk

7. Want to hedge their fixed income portfolios

8. Want principal protection

9. Want to possibly earn a higher return than what a traditional fixed annuity offer

10. Want “income later” but don’t want to lose control of the assets like in a SPIA. You do this with an index annuity with an income rider.

Free Withdraw Options

Most index annuities allow you to withdraw a portion of your money penalty-free.

Withdraw options vary from product to product. Do your research.

The IRS also charges a 10% penalty for any withdrawal before age 59 1/2.

Insurance Company Withdraw Example

Year 1 - 10% of the account balance

Year 2 - 10% of the account balance

Year 3 - 10% of the account balance

Year 4 - 10% of the account balance

Year 5 - 10% of the account balance

Year 6 - 10% of the account balance

Year 7  -10% of the account balance

Surrender Charges

Surrender charges are a percentage charged to withdrawals after taking penalty-free withdraws.

Surrender charge example from a real product

Year 1 - 7%

Year 2 - 6%

Year 3 - 5%

Year 4 - 4%

Year 5 - 3%

Year 6 - 2%

Year 7 - 1%

Year 8 - 0%

If the index annuity is owned until maturity, there are no surrender charges.

What to do When an Index Annuity Comes Due

When your contract matures, you have several options. Your insurance carrier usually mails you a letter. And the insurance agent servicing your account should contact you as well.

1. Take your money out. You can take out the balance in a one-time payment. Let the insurance company know you want your money! Taxes would be due on all the earnings portion of the withdraw. If you are less than age 59 1/2, you also get a 10%

penalty. You can also have the insurance company send you the balance over a few years instead of a lump sum. Some do this to spread their tax bill over a few years instead of all at once.

2. Your insurance company should send you a letter when the maturity is near. You can decide to keep your money with them if you are happy. Pay close attention to your maturity dates!

3. You can transfer your balance into an index annuity at another company. Why? To get a better deal! Always shop the market before making a decision. Make sure to do a 1035 tax-free transfer to keep the money growing tax deferred. Section 1035 is part of the IRS tax code dealing with “tax-free” exchanges.

4. You can convert your account balance into an immediate annuity. You can do this with your existing company or do a 1035 tax-free transfer at another company. An immediate annuity is a permanent decision, so make sure to properly plan for this. If you own an index annuity and are paying the income rider fee, you may want to keep the product. Speak to a specialist for more information.

Shopping for the Best Index Annuity

3 reasons you absolutely must shop around to find the best rates:

1. Many banks and investment firms have an “approved list” of annuities they offer. The list is made of annuities they sell. Not all annuities are on these lists. I worked for two banks earlier in my career, and we only had access to a small number of products. Make sure to shop around. Some companies don’t sell index annuities at all. So they would be biased.

2. Many insurance agents don’t show you all of the products either. They have a few favorite annuities and sell them to everyone. Look for an independent agent who can show you research from third parties and rank the best products. Request a quote and we can do this for you.

3. Many companies don’t want to show you fixed annuities at all. Why? Because they don’t sell them.

Request a quote and one of our specialists will send you a summary of the best index annuities on the market, customized for your situation.

17 Index Annuity Tips

1. Have the right expectations. Don’t expect market returns. They are classified as fixed annuities and generate fixed income types of returns.

2. Diversify crediting strategies and indexes. Don’t put all of your eggs in one basket.

3. Be careful with unproven and untested indexes. Companies can run hypothetical illustrations to make anything look good. You won’t get the best-case scenario.

4. If someone promises you 7-10% returns, run, don’t walk away. They are lying to you.

5. If you want “income later,” compare index annuities with an income rider to a longevity annuity (DIA). The longevity annuity might require less money upfront. This allows you to keep the rest of your money invested in the market. Most insurance agents don’t do this because their commission would be reduced by 50%. Our specialists can help provide this analysis.

6. No caps don’t mean unlimited upside. Some products can shift the money to cash.

7. Don’t trust hypothetical illustrations. Have the company run a worst-case scenario, so you know what it is. Hypothetical illustrations are fantasy land. Don't expect to earn the return in the hypothetical illustration.

8. Trust but verify. Do your homework.

9. You can’t lose money in an index annuity if you hold it for the entire surrender charge period. You won’t lose money due to losses of an index. But, if you withdraw the money early, you WILL lose money.

10. Keep your annuity balances below the state guarantee coverage limit. You should contact your state to find out if their guarantee is “per person” or “per insurance company.” This should affect your decision.

11. Buying an index annuity is a big decision. Take your time and act when you feel comfortable. Don’t let anyone pressure you into making a decision.

12. Understand what you are buying. If you don’t understand it, don’t buy it. Before signing a delivery receipt, make sure you know everything about your annuity. If you have questions, our specialists can help.

13. Review your index annuity at least annually. You might want to target a different index the next year. You also want to review the gains.

14. Consider the rating of the company. You should choose a stable, highly rated company.

15. Don’t invest too much of your assets into index annuities. Consider diversifying what you do invest in different indexes and strategies.

16. Work with someone you can trust. If it feels too good to be true, it probably is.

17. Annuities pass via beneficiary designation. Make sure your beneficiaries are up to date at all times.

18. Look for a company that offers attractive renewal rates/options to their customers. Because insurance companies can change the formula which determines your return every year or two, it's very important you find a company that will treat you well.

What You Absolutely Must Know Before Buying

1. How long the term is for. You absolutely must know how long your money is being locked up. In 2003, I had a 70 something-year-old man break down on the phone with me when he realized his insurance agent never told him his money was locked up for seventeen years. He said, "Scott, I just kissed my savings goodbye for the rest of my life."

2. How are gains calculated? You must know which index your gains are linked to and how the gains are calculated.

3. Are there any fees? Index annuities don’t usually have fees, but they have optional “riders” which do. Don’t pay for riders that you won’t use. For example, don’t pay for an income rider fee of 1% if you don’t need income. It’s a waste of money. You must pay the rider fee every year, forever.

4. The commission. Ask your agent what the commission is. I think it’s a fair question that you deserve to know.

Index Annuity Commissions

Index annuities offer high commissions to insurance agents. They are usually higher than SPIA, DIA, MYGA, or traditional fixed annuities. Commissions range from 3-9%. Generally speaking, the longer-term products have the highest commissions. If an insurance agent tries to sell you a 16-year index annuity, run, because they are trying to maximize their commission and _______ you.

Important Terms to Know

Participation Rate - An index annuity is linked to an external index (for example, S&P 500). The participation rate is the percentage of gain you receive in the growth of the index. It’s what percentage of growth you participate in. For example, if the index increases 20% and the participation rate is 60%, then the annuity would be credited with 12% interest.

Interest Rate Spread - This is an alternative to the participation rate. The spread is like an interest rate deductible. Once the spread is hit, all gains are credited to the contract up to the cap. For example, if the interest rate spread is 5% and the index gains 20%, the annuity would be credited 15% (up to the cap).

Cap Rate - The cap rate is the “cap” on the gains you can receive in the period. It’s the “cap” on the gain. The participation rate and interest rate spread are subject to the cap.

Averaging - Many index annuities “average” out the value of the index. They don’t use the index value on one day, but the average of the month, year, or several years. Averages can smooth out gains and protect from big swings in the index, which would wipe out a big gain.

Interest Crediting Methods

There are many crediting methods, but these are the most common.

The Annual Point to Point Method - The most common crediting method is annual point to point. It’s also the easiest to understand. It’s merely the percentage gain in the index of the period. Losses in the index do not create losses in the annuity.

Ex. Index loses 25%. The credit would be zero

Index gains 25% The credit would be 25%

The gain of 25% would then be subject to the participation rate, caps, and spreads above.

The monthly cap method - You simply calculate the index change each month for 12 months. Add them up for 12 months. Then, divide by 12. Then apply the cap rate to this gain.

The term point method - Used when the crediting period is several years. You simply take the percentage gain from beginning to end. Then apply the participation rate. Then apply the gain to the beginning of the crediting period.

We hope you have enjoyed reading this article.