Introduction to Annuities: Indexed Annuities

In the last section, we examined fixed annuities and the type of investor for whom they are appropriate. This section covers indexed annuities, one of the newer offerings in the insurance marketplace. These contracts mirror fixed annuities in that they offer a guarantee of principal and a set term, but they do not pay a fixed rate.

How You Make Money

Indexed annuities, as the name implies, will invest in one of the major stock market indices, usually either the S&P 500 or the Nasdaq (although the latter option has diminished considerably since the dotcom bubble burst). The contract owner receives a share of the market's growth (if there is any), while avoiding any possible downside risk. There are several different methods that companies use to credit their contract holders with market gains, including:

Annual Reset – The annuitant is credited with a return each year that the market exceeds its previous year's level. If it does not, then no gain is credited, but no loss it taken either.

Point to Point – Measures the change in the index from the start of the contract to the end of the term (which can be anywhere from one month to as long as five years in some contracts). In a continuous bull market, point-to-point annuities will usually offer the highest returns.

High Water Mark with Look Back – This simple design "looks back" over the term for the highest anniversary value over the term.

Many indexed annuities base increases on average values of the index over a term. Be sure to read the fine print: An annual reset contract may calculate index gains on the average value of the index between anniversary dates, as opposed to the anniversary value itself. Some fixed contracts also charge a spread or asset fee that is subtracted from the total return realized. Other contracts also pay based on an index's average value over a given period of time instead of its closing value, which can reduce the amount credited to the investor.

Downside Safety, Upside Growth Limits

Most indexed annuities include several other parameters besides market value. One of these is a guaranteed fixed rate, for example 1%, that will pay out if the market drops or does not gain during the contract term. For example, if the market index dropped during the term, then the contract owner might get a 1% increase – a protection against downside loss. The rate that will be paid in this scenario will generally be much less than the prevailing fixed annuity rates and could most accurately be described as a consolation rate. It will provide the owner with a nominal gain in return for keeping the contract invested with no gain for the full term. In the current market, guaranteed fixed rates of 0% may be offered (in essence, a guarantee you won't lose money).

Another major characteristic of indexed annuities is the rate cap. While indexed annuities are designed to offer market gains with no downside, there is a price for this security. If the index jumps by 10% in one year, it is unlikely that the contract owner will enjoy the full amount of this gain. Usually, most indexed contracts stipulate a maximum amount of gain (or cap) that may be paid to the owner in a given year. That could be 3%. The excess gain goes to the insurance company to cover costs.

Another type of restriction is a percentage limitation on index's return, also known as the participation rate. Instead of the absolute limit imposed by a cap, the investor may get a specified percentage – say 70% – of the index gain in a given year. If the market went up 30% in a stellar year, the investor would get 70% of that 30% gain, which comes to 21%. In some cases, both types of restrictions will be in the same contract, potentially pushing the return far lower than 21%. The insurance carrier can change the par rate on the contract anniversary (or biannual anniversary, depending upon the length of the crediting period chosen by the investor), so it does not necessarily stay constant for the life of the contract. Most annuity contracts will at least state a guaranteed minimum participation rate. 

How Insurance Companies Make Money

Behind the scenes, insurance companies are able to fund indexed annuities by investing the contract proceeds in a combination of derivatives and guaranteed investments. If the market goes up, the derivatives will increase enormously in value, thus providing the upside necessary to credit the contract owners accordingly. If the market decreases or stays flat, the guaranteed investments will provide the consolation interest instead.

We will examine variable annuities in Section 7.