Indexed Annuity

An indexed annuity (fixed indexed or equity indexed annuity) is an annuity program offered by insurance companies that allow individuals to earn a return based on the market index's performance. The primary aim of this annuity is to provide combined benefits of both fixed and variable annuities. 

The fixed indexed annuity provides a guaranteed return on investment. Also, there is a better incentive for the annuitants to earn from market indexes. As a result, it becomes an ideal match for those choosing a long-term investment. However, these gains can be limited as well as unpredictable. 

• An indexed annuity (fixed indexed or equity indexed annuity) is an annuity contract where individuals get the benefits of both fixed and variable annuities. 
• They earn minimum guaranteed returns on the investment based on the market index's performance. For example, if S&P 500 rises, the returns will also rise. 
• On early withdrawal, there is a surrender fee of 7% charged on the withdrawal amount. In addition, there are many other costs associated with it. 
• Some indexed annuities are controlled by SEC and state insurance regulations. For example, security is controlled by the former and the rest by the latter. 

An indexed annuity refers to a contract with insurance companies that provide guaranteed returns based on market index performance. Thus, the return earned is on an annual basis. Also, it is a combination of a fixed and variable annuity. However, unlike other annuities, the SEC (Securities and Exchange Commission) cannot control them. 

Usually, there are two phases or processes in an indexed annuity. It includes the accumulation and payout phases. In the accumulation or savings phase, an individual will pay a premium, either in lump sum or installments, to the insurer. The insurance company will later invest the amount in leading market indexes. So, in case the index performs better in a year, the insurer will credit (transfer) the returns to the annuity owner. Later, in the payout phase, they will make periodic payments to them. However, individuals can still receive a lump sum on maturity. 

Payments for indexed annuities happen either on an immediate or deferred basis. In the former case, the insurer will make payments within a year. However, they will hold the money for at least a year before distribution in the deferred annuity. If a person wants to withdraw before maturity, they have to pay a surrender fee of 7% of the withdrawal amount. 

Besides, there are various fixed indexed annuity fees attached to it. Some include return limits, mortality and expense fees, and administrative fees. Other indexed annuity fees include rider fees that provide extra benefits on the existing annuity. 

However, not all equity-indexed annuities are subject to SEC regulations. If the annuity is a security, the SEC will control them. Also, they will deliver a general prospectus under its name. They have the potential for losses. In contrast, others are controlled by the state insurance regulation that protects them from investment losses. 

The origin of indexed annuities dates back to the late 20th century in the United States. The Great Bond Massacre of 1994 was the major cause of this annuity. At this time, the federal interest rates were shooting high by 1.5%. The inflation rate was as high as 2.56%, and people were trying to hold money within their pockets. Thus, a new variant of annuity arose in this chaos. In 1995, Canadian insurance company Keyport Life launched "Indexed annuity." Later, along with Genesis Financial of Canada, Keyport launched KeyIndex in the same year. From 1997 to 2008, the cash flows increased from $3 billion to $26 billion. 

Let us look at the methods to calculate indexed annuity rates and associated values:

#1 - Annual Monthly Average Method

In this method, the indexed annuity rates are linked to the index's performance over 12 months. Later, the insurer takes the average movement of the index and calculates the value. However, the value depends on the annuity cap, where if a cap rate is 6% and the index performs 8%, the person will receive only 6%. 

#2 - Annual Point-to-Point Method

The point-to-point method is a credit strategy where the rate is calculated on the starting and ending points of the index. For example, if an index's value in 2019 was $1700 and by the end of maturity was $1900, the rate will be calculated on the annual performance. 

#3 - Annual Monthly Cap Method 

Here, monthly increase and decrease in the index are added to determine an index value. If the monthly increase is positive, then the annuitant will receive a profit.    

Let us look at a few examples of equity indexed annuities to understand the concept better:

Example #1

Suppose Scott is a sales executive in his mid-20s. He seeks to make a huge return on investment. However, Scott fears market volatility and refrains from investing in stocks. Therefore, his colleague Jonathan suggests investing in indexed annuities where he receives fixed and variable annuities benefits. It means that he will receive a guaranteed and a more-than-average return based on how a market index performs. So, if the index rises by 5%, Scott's investment will also rise. As a result, he will receive fixed returns on the principal amount. 

Example #2

According to a 2022 report by LIMRA, in the last quarter (i.e., October), the sales of deferred indexed annuities assets were $559.4 million. However, before the COVID-19 pandemic (2019), it was $496.4 million. In the last decade, there was an increase of 173% from 2011 to 2021. 

Indexed annuities are a popular option to earn returns by hedging risk. However, there are certain pros and cons to the concept. Let us look at them:

Although an indexed annuity is a combination of variable and fixed annuity, they have distinct differences. Let us look at them:

This has been a guide to what is an Indexed Annuity. We explain its pros, cons, example, comparison with the fixed & variable annuities, history, & examples. You can learn more about it from the following articles –

• Immediate Annuity
• Life Annuity
• Annuity Certain