Index Annuity Basics

Index annuities are fixed annuities that have the interest you receive tied to a stock market index. An index annuity is ideal for investors who want to participate in market-related returns yet are uncomfortable with market risk. But with about 40 known interest crediting methods, you may find that even if two index annuities are linked to the same index, their returns might not be the same. That's because these index annuities have several moving parts as described below. (if you own an annuity and are not sure about some of the features, see Annuity Review).

The Participation Rate in an index annuity is the amount of the increase (not including dividends)
in the underlying index that will be credited to your index annuity. For example, suppose the index (the S&P 500) increased 9% and the participation rate is 70%. The index annuity will be credited with 6.3% interest (9% x 70% = 6.3%).

Annuity companies can set different participation rates for newly issued index annuities as often as each day. Therefore, the initial participation rate will depend on when the company issues your index annuity. Annuity companies usually guarantee the participation rate for a specific period (from one year to the entire annuity term). Then when that period is over, a new participation rate is set for the next period. Some annuity companies promise that the participation rate will never be set lower than a specified minimum or higher than a specified maximum.

However, you should insist on a fixed participation rate for the entire annuity term.Some annuity companies may provide 100% participation today, but if they change that to 50% next year, you won;t be happy. Therefore, look for an index annuity with a fixed participation rate for the entire term.

Try to get an index annuity with an Annual Reset. This feature compares the index value at the end of the contract year with the index value at the start of the contract year. And it is especially important for retirees as the gains are better protected from subsequent declines in the index. Without the annual reset feature, you cannot protect one year's gain from the next year's loss. There's nothing worse than when you make 30% one year then lose it the next. If you want to take that risk, you may just as well be in a variable annuity or in a mutual fund.

However, in every case of an index annuity that offered an annual reset, we have seen it combined with an averaging feature, which is not beneficial.

Averaging of the S&P 500 at the beginning of a term is supposed to protect you from buying at a high point in the index cycle, which would reduce the amount of interest you might earn over the term. Averaging at the end of the term protects against severe declines in the index and losing index-linked interest as a result.
And while most annuity companies claim that this is a good feature, it's not beneficiaial for the index asnnuity owner. It dilutes the return. However, it's nearly impossible to find a product that doesn't use averaging.

Based on an analysis of periods over the past 30 years, an index annuity with a 55% participation and no averaging will do about as well as a 100% participation, with averaging. However, from the annuity owner's view, the 100% sounds better.

The best index annuity performance will come from the riskiest arrangement: A point-to-point design
with no averaging. The point-to-point method calculates the interest return every contract year and then, ultimately, combines these returns to arrive at the total return for the contract term. This permits index annuity owners to take advantage of a market recovery after a year of losses. The change in the index is a 'price change only' measure and does not reflect dividends.

The high-water point, or high-water mark, is a variation of the point-to-point termmethod. Rather than using the ending point, the calculation is based on the highest
obtained value during the term of the contract based on annual contract anniversary index values. For example, if the index doubled its original value on the first anniversary date and then proceeded to decline for the remaining contract period, the high-water point
method would calculate an index return of 100%. The high-water mark is locked in no matter how much the market may go down. This is a beneficial index annuity feature for the investor.

Any type of Annual Cap has a significant effect on returns. Most people don't realize that two or three years out of 10 produce the big gains in the stock market. If you remove those big gain years by capping them, the performance dives. Averaging of the S&P 500 reduces those big gains. And since index annuities already protect the original principal, there can be no argument that averaging provides any value in down markets. Try and avoid index annuities with any type of cap.

Index annuities are not designed to outperform the index long term. So you will not earn anything near what the stock market delivers. Index annuities will deliver about 40%-65% of stock market returns. So if the stock market has delivered a 12% return over time, figure an index annuity (with the averaging feature) will deliver 6%.

Start with the retirement planning calculator to see how index annuities may fit into your retirement income strategy and then use the fixed annuity calculator to determine what part a fixed annuity can play in your retirement portfolio.

Most Annuity Owners Make This Mistake

To get wealthy, invest like the wealthy

Why the wealthy steer clear of mutual funds

How the rich systematically make money in the market

Key metrics that differentiate good and bad investments

A comparison of ETFs and separately managed accounts you have never seen

Stop making the same investing mistakes as everyone else who listens to CNBC and reads Money Magazine. Do what the rich do! Free guide explains how they think and make investment choices.