An annuity is a retirement savings vehicle, which grows tax-deferred. Besides fixed annuities, ones that credit your account with interest, similar to a CD, there are variable annuities, ones you invest money in mutual funds called sub accounts and indexed annuities. Indexed annuities give you a percentage of the returns of a particular index, such as the S&P 500. Then the company credits your account with the gain or a guaranteed minimum percentage.
In a variable annuity you can switch the way you invest your funds. You have the option of putting your money into several different types of funds such as large cap stocks, foreign stocks, bonds and money market instruments. In the indexed annuity, you only participate in the return of one particular index or receive a guaranteed minimum interest return if that index doesn't show a high enough growth or loses money. There are no other options once you enter the contract.
Variable annuities give you the whole return for the funds where you invested your money. If you put all your money into small cap growth and that fund returns 23 percent, your account grows 24 percent. However, with indexed annuities, if the index grows by the same 24 percent you'll not receive the full amount. When you select a contract, you also select a participation level. The higher the guaranteed return you select, the lower the participation level you receive. If you chose 50 percent participation with a guaranteed return of 5 percent, you'd only make 12 percent in a year the index returned 24 percent.
Many indexed annuities also have a cap on the amount of money you can make on your investment. The cap also affects the percentage of your guaranteed return. If the index returns 24 percent and you have 50 percent participation but also a 10 percent cap, you'd only make 10 percent. The variable annuity has no cap on the amount you can earn.
The guaranteed minimum interest is part of the allure of the indexed annuity and it applies to living benefits and death benefits. There are no guarantees on the return of a variable; unless your company offers riders and you purchase them. The approximate cost of the rider is between a fraction of a percent, such as 0.85 percent, and 1 1/2 percent each year for living benefits. These often guarantee a specified return or the return of your initial investment. However, you have to remove the money in a specific way or leave it in the contract for a certain number of years. If you want the same guarantee on the death benefit, you have to pay for another rider.
The indexed annuity simply follows the movement of a particular index. There is no selection of stocks or management involved. In the variable annuity, some of the funds have managers that select the best stocks and bonds for the funds. These managers receive payment, which lowers the fund returns. Sometimes, the fund managers produce winners, which far exceed a particular index, but that's not always the case.
In addition to flexibility, many variable annuities offer automatic asset allocation. You select the percentages of each investment you want or use one already prepared by the company for various levels of investment risk. As the markets move, some funds will grow dramatically and others lose. The company automatically sells the gains and reinvests in the ones that lost to maintain balance. That way, you're always selling high and buying low. The indexed annuity only uses one index so there's no possibility for asset allocation.
- New Hampshire Department of Insurance: Annuity Buyer's Guide
- SEC: Variable Annuities: What You Should Know
- SEC: Annuities
- Insurance Jouranal: SEC Moves to Regulate Some Equity Indexed Annuities
- FINRA: Investor Alert-Equity Indexed Annuities a Complex Choice
- Forbes: Equity-Indexed Annuities: A Costly Way to Limit Your Losses