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%.

Taking a deeper dive, over the 10-year period ending December 31, 2016, there were times (2 times in this 10-year period) where the representative indexed annuity provided protection against the negative returns in the U.S. equity markets, but there were many more times (8 times in this 10-year period) where the index annuity returned only a small portion of the positive U.S. equity market returns.Looking at some extremes, for the annual period ending December 31, 2008, the indexed annuity guarantee provided strong protection, preventing large losses in that year as the S&P 500 annual return was -38.49%. However, there are five years where the S&P 500 significantly out paces the annuity because of the indexed annuity’s cap on upside returns, as highlighted by years ending 2009, 2010, 2012, 2013 and 2014 (for these years, the S&P 500 returned 23.45, 12.78, 13.41, 29.60 and 11.39%, while the indexed annuity returned 0.00, 0.00, 2.26, 9.98 and 3.28% each year respectively).

As can be seen from this example, with indexed annuities you are giving up equity market return potential in exchange for downside market protection.

In reality, Indexed annuity returns are typically comparable to a conservative investment product’s returns, and not to the stock market, a stock market index, or stock fund returns.

“Investors often mistakenly think they are investing in the market directly with an indexed annuity and are surprised when their actual return does not measure up,” says Tim Gannon, a vice president of product management at Fidelity Investments Life Insurance Company.

How much do they cost?

Indexed annuities typically do not have an up-front sales charge, but there are often significant surrender fees—fees you pay if you need access to your money before the surrender period ends—and other hidden costs. “While indexed annuities are often sold as ‘no-fee’ products, investors still incur a cost to own these products, by giving up higher returns in exchange for guarantees,” explains Gannon. In addition, surrender fees for the 10 top-selling indexed annuities averaged 11% in the first year.5

“Also, indexed annuities have significant opportunity costs that are passed on to customers by the insurance company, by limiting potential returns through a participation rate, cap, or spread,” notes Gannon. “That’s why it is important to ask your agent to explicitly define how the product works, so you will know up front about any factors that could put a drag on your potential return.”

Can you lose money?

The answer, in some cases, is “yes.” If the market index linked to your annuity goes down and you receive no or minimal index-linked return, you could lose money on your initial investment if you withdraw assets before the surrender period is up.

“Your principal is protected only if you hold the annuity through the surrender period, which could be 10 years or longer,” says Ewanich. “Unfortunately, many investors believe that, regardless of what happens in the market, they get all their money back with these products. But this is not always true.”

So what is the minimum amount you might get back? According to state insurance laws, indexed annuities must guarantee a minimum of 1% to 3% interest each year on 87.5% of the premiums you invest6, depending on prevailing interest rates at the time. So, if you invested $100,000, you might be guaranteed from 1% to 3% a year on $87,500.

What’s more, in an effort to attract more customers, these products are offering certain riders for an additional cost. For example, many companies offer a guaranteed living withdrawal benefit at an average cost of nearly 1% that promises a guaranteed withdrawal amount7 for life with upside potential. Because of the indexed annuities’ participation rates, spreads, and caps, however, upside potential is generally limited. Be sure to determine whether the benefits outweigh the extra cost.

Does it fit your needs?

“Indexed annuities can be a challenge to understand, so be sure to do your homework,” advises Gannon. Depending on what you are looking to address, it may be in your best interest to consider a different type of annuity or a combination of investment products.

For example, for principal protection and market participation, you may benefit from a strategy that invests a portion of your assets in a conservative investment, such as bonds, and the remaining portion of your assets in the stock market, for upside potential.

“A financial representative can help you build a comprehensive plan that takes into account your specific needs and objectives,” says Gannon.