Indexed and Fixed Indexed Annuities – How They WorkJanuary 1st, 2013 by David Waring
Well, lets dive into the details:
The guaranteed return is absolutely true, however its usually around 1%. This is much lower than you would receive with a similar length fixed annuity or other fixed rate of return investments of similar duration. The guaranteed return does however protect you from losing your principal investment, so no matter what the stock market does (even if it was to fall 20% for example), you would not lose a dime of your initial investment.
An indexed annuity does provide great potential upside.
Your annuity can go up in value with the stock market, as measured by the performance of a stock index like the S&P 500, the Dow Jones Industrial Average, or the Russel 2000. An indexed annuity does not however provide unlimited upside as the annual return is usually capped to under 10%. This means that if the stock market rose 15% for example, and you had a 10% cap, you would miss out on the additional 5% gain above your 10% cap. Instead of, or in addition to a cap, some indexed annuities have participation rates. This means you you only see a certain percentage of the gain realized in the index. As an example, if you had a 60% participation rate and the market rose 15%, your return would only be 9%.
An indexed annuity does not give you the unlimited upside that you would receive when investing in an index ETF or index mutual fund.
They also normally do not include dividend payments in their calculations of return, so you do not get the benefit of dividends like you would with the Index mutual fund or ETF either. What you get in return for giving up these benefits is the protection against losing money, which is not offered with index mutual funds or ETFs. With an index annuity you are essentially trading some of the upside of investing in the stock market, for the guarantee of not losing money. Put another way, you are taking less risk, but also receiving less upside potential.
How does an indexed annuity compare to variable annuity?
Variable annuities don’t have any guarantee of returns or principal protection. Indexed annuities guarantee both your principal and a small annual rate of return.
Variable annuities have unlimited upside potential. The upside return on index annuities is capped.
Variable annuities have many investment options. You can allocate your funds between several choices and change your allocations over time. With a fixed indexed annuity, you are be able to split your money between a fixed annuity and and indexed annuity. This basically means that the investment choices in an indexed annuity are restricted to choosing a stock index.