What is the Greatest Disadvantage of an Equity-Indexed Annuity?
Index-linked annuities provide growth potential while protecting against losses, while at the same time providing some protection. Unfortunately, many of these products limit returns with performance caps or participation rates and spread/margin fees that reduce returns significantly.
Before choosing an equity-indexed annuity as your retirement investment vehicle, it’s essential that you understand how they work as well as their main advantages and disadvantages. In this article we’ll address this topic along with guaranteed returns, fees and how returns are calculated.
Guaranteed Returns
Equity-indexed annuities offer guaranteed returns, yet come with certain restrictions and limitations on their growth potential. Many annuity contracts come equipped with participation rates and caps which limit how much of an index’s return gets credited back into your account.
Example: If an index increases by 10% and your participation rate is 80%, only 7% will be deposited to your account. Furthermore, some indexed annuities may include spreads or asset/margin fees which reduce returns further; it is therefore crucial that contract details are read carefully in order to ascertain if these products fit within your retirement portfolio or not.
Fees
Hallie is a retired widow looking to bolster her Social Security payments with additional income streams. She’s considering an equity-indexed annuity because it provides upside potential while offering downside protection; however, before making her final decision it’s essential she understands all associated fees before purchasing one.
An investor should first take note of their participation rate, which governs how much of an index’s gains will be credited back into an annuity. For instance, if an index linked to your annuity increases by 10% but participation rate only allows for 80% participation – investors will only see 7% return instead of 10.
An annuity’s main expense is the “spread” or interest rate spread fee. Similar to an AUM fee charged by investment products, annuities charge this additional cost that reduces investors’ index returns. Furthermore, administrative and mortality expenses may also apply; all these charges cover risk from insurance companies.
Taxes
Equity-indexed annuities offer advantages over traditional fixed annuities by taking advantage of stock market returns to generate some gains while protecting principal from losses. Before purchasing such products, however, it is crucial that you fully understand their workings and risks involved before making your commitment.
Participation rates, caps, spreads and index calculation methods all play an integral part in an indexed annuity’s potential returns, with some even going as far as to reduce or even make them negative. These factors vary between policies which could drastically change an annuity’s potential returns or even cause them to go negative altogether.
These factors can be confusing, particularly when insurance agencies and salespeople employ high-pressure tactics to market indexed annuities. Salespeople might focus on using promotions such as free dinners or giveaways in an attempt to draw in uninformed clients; this approach, however, should not be seen as an appropriate means for investing. Given that industry debate over their suitability is still ongoing and thus advised prior to purchase; to find one nearby use the FINRA directory.
Time horizon
As with other investments, the longer you hold onto an index annuity the greater its growth potential may become apparent. Unfortunately, however, many insurance companies include provisions in their contracts which limit this growth – such as participation rates or rate caps.
These provisions reduce index-linked interest credits in years when the market declines, and limit how much your account balance increases during any given year if an index rises. This method of calculating gains – known as point-to-point calculation – typically results in less dramatic account balance increases than some companies’ percentage-of-index-rise methods do.
If your client has a limited time horizon and limited knowledge of how the stock market operates, an equity-indexed annuity may not be an appropriate component of their retirement savings portfolio. On the other hand, it could make sense if they understand its charges and limitations so as to be included as part of an overall retirement plan.
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