The Pros & Cons of Indexed Annuities

An annuity is a retirement savings product sold by insurance companies. The common fixed annuity pays a set rate of interest. A different type of product, the equity indexed annuity, is designed to pay a portion of the annual return of a stock market index -- such as the S&P 500 -- with a guaranteed minimum interest rate if the stock market does not go up. Equity indexed annuities can be sold by licensed life insurance agents as well as by registered investment advisors.

The stock market is considered to be the best asset class for long-term growth. An equity indexed annuity promises to pay a portion of that growth and in good years the return on this type of annuity could be very attractive. If, for example, an annuity will pay two-thirds of the annual return of the S&P 500 and the index goes up 30 percent during the year, an equity index account value would increase by 20 percent. If the stock market goes down, the value of the annuity does not go down. Instead, the annuity owner would earn the guaranteed minimum interest rate listed in the annuity contract.

Annuities -- including equity indexed annuities -- allow any earnings to grow tax-deferred until money is withdrawn in retirement. Tax deferral allows the annuity value to grow faster, since money does not have to be withdrawn to pay taxes on the gains. Unlike an IRA, there is no limit on how much money can be invested in an annuity to achieve tax-deferred earnings. The idea behind tax deferral in an equity indexed annuity is that the account value will grow larger in the annuity compared with the growth in a comparable taxable investment, such as a stock mutual fund.

The terms of an equity index annuity can be very complicated. The problem arises when trying to determine which portion of the stock market is indexed, how much of the market gains go to an annuity holder and the time frames involved. The different equity indexed annuities issued by different life insurance companies have different ways of calculating gains. It is very difficult to accurately calculate how one of these annuities will perform using different stock market results.

Equity indexed annuities are designed to be long-term investments and the insurance companies impose surrender fees if money is withdrawn early. The surrender fee period for this type of annuity may be up to 15 years and the surrender fee as much as 20 percent in the early years. In contrast, the typical fixed annuity may have a surrender fee period of only five or six years. If withdrawals are made from an annuity before the owner is age 59 1/2, the tax rules impose a 10 percent penalty on any gain. Regular income taxes will also be due on any gain from a cashed-in annuity.