What Is an Indexed Annuity?

An indexed annuity is a kind of variable rate annuity. Instead of rising and falling line with a portfolio of different kinds of assets, though, an index annuity tracks a particular index. It might follow the Dow Jones or the Nasdaq, for example.

The advantage is that contract owners aren’t stuck with the lower, guaranteed growth of a fixed rate annuity. And they have more transparency than a variable rate annuity with a general portfolio of mutual funds. They know which index they’re tracking and how it’s doing. When an index is doing well, they can benefit from that extra growth. And when that market takes a tumble, the returns will fall too.

Or at least, the contract owner will gain some of that growth because indexed annuities don’t deliver all of the benefits of the rise of the index it tracks. Indexed annuities usually come with a “participation rate” that limits returns. If a participation rate is 75 percent, for example, a 5 percent rise of the tracker index would only deliver a return of 3.75 percent to the owner of the annuity.

In return for that lower return, though, the owner of an indexed annuity can expect to see some sort of guaranteed minimum interest rate. Even if the index you’re tracking takes a dive, you’ll have some protection and you can still expect your money to grow and deliver revenue in the future.

Those limits on both gains and losses make an indexed annuity a very special kind of investment. They maintain some of the volatility of the stock market and promise some of the benefits of a growing economy. But they’re investment-lite. You won’t reap the full benefit of a boom, and you won’t feel all of the losses of a bust.

Annuities Shouldn’t Be High Risk

And that’s the way any kind of annuity should work. An annuity shouldn’t be a risky investment. You shouldn’t wonder whether your money will still be there when you reach the withdrawal phase. You shouldn’t even have any doubts about how much money you’ll receive when you begin receiving your payments. The most important return you receive when you buy an annuity is certainty. You know that when the time comes you’ll have a particular income waiting for you.

The guarantee in an indexed annuity gives you that certainty. It delivers a floor that ensures you’ll have a certain level of income. The index tracking might not give you all of the benefits of a market boom, but it will give you a chance to increase your earnings in line with market performance.

So if you’re considering buying an indexed annuity, you should compare the participation rate across competing products. You should also look at which index the annuity tracks, and check its performance over the last few years (although past performance never guarantees future performance.)

Pay most attention to the guaranteed rate in the income rider. That tells you the minimum return that you’re buying. Consider anything on top of that as a bonus.

One useful strategy for indexed annuities is to combine them with fixed rate annuities. You’ll get the stability of the fixed rate annuity and at least some of the potential of the indexed annuity. You can either increase your budget and buy two complete annuities or you can add to the stability of an indexed annuity by splitting your funds between the two contracts.

A fixed-rate annuity just gives you a small, extra element of risk that you can work into your portfolio.

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