A fixed index annuity can be a reasonable choice for a slice of money that must not fall. It is a poor choice if you are buying it because someone told you it gives you the stock market’s gains without the risk. It does not, and the contract says so.
Here is how it actually works, using the SEC’s own investor bulletin on indexed annuities.
The trade you are making
You give an insurance company a sum of money for a number of years. In exchange, your return is tied to a market index, with limits on how much you can lose and limits on how much you can gain.
The protection is real. The cost of the protection is hidden in how the gain is counted.
Four ways the gain gets smaller
Dividends are usually left out. The SEC’s example: an index has a total return of 7% in a year, and 2.5% of that came from dividends. Many indexed annuities would count the index’s return as 4.5%.
The participation rate. You may be credited with only part of the gain. With a 75% participation rate and an index return of 10%, you are credited 7.5%.
The cap. A ceiling on what you can earn in a period. With a 7% cap, an index gain of 12% is credited as 7%.
The terms can change. Contracts commonly allow the insurance company to change some of these features during the life of the contract. The rate you were shown at the sale may not be the rate you get in year four.
Put those together and you understand why many owners look at their statements after a strong market and wonder why the balance barely moved.
The floor is in the brochure. The ceiling is in the contract.
The parts nobody mentioned
Surrender charges. Leaving early usually costs you a percentage of the account, for years. Ask for the schedule.
Commissions. These products often pay the seller well. You do not see it as a line on a statement, because it is built into the terms you receive.
Taxes. FINRA notes that annuity gains are taxed as ordinary income, not at the lower rates that apply to long-term stock gains, and withdrawals before age 59½ can carry an extra 10% tax.
Riders. Income guarantees and other add-ons carry their own yearly fees.
When it can make sense
When the real comparison is with other safe money. If the choice is between this and a bank CD or a bond for a portion of your savings, and you will not need the money during the surrender period, the comparison is fair.
When the comparison is with the stock market, it is not. The product is built so that you get a part of the gain, and the insurer keeps the rest to pay for the floor.
Six questions before you sign
What is the cap today, and what is the lowest it can be set?
What is the participation rate today, and what is the lowest it can be set?
Are dividends included in the index return?
What is the surrender schedule, year by year?
What is the guaranteed minimum value if the index does nothing for ten years?
How much are you paid if I buy this?
Ask for the answers in writing. Then sleep on it. A good product is still good next week, which is the point of The Pre-Decision.
Related questions: should I cash out my annuity, variable annuity fees, added up, what a structured note really is and should I roll my 401(k) into an annuity.
One question for this week: if you already own one, what was it credited last year, and what did the index itself return? Put the two numbers next to each other.
As always, if you want to talk any of this through, the door is open. Genti