Indexed Annuities Problems
Saving money for your future is essential. You have many options, including government-sponsored retirement plans such as IRAs and 401k accounts. Annuities are a private contract alternative to these government plans. One popular type of annuity is an equity-indexed annuity. But indexed annuities do have some problems that you should know about before investing in one.
Other People Are Reading
-
Function
-
Indexed annuities earn interest based on the upward movement of the stock market. They do this by investing in a precise mix of bonds and index call options. An index call option is a stock option. Options give you the right, but not the obligation, of investing in a particular stock. An index option gives you the right to invest in the value of the underlying index. For example, an S&P 500 index call option gives you the right to invest in the value of the S&P 500 stock market. When the stock market, as a whole, increases in value, so does the stock option. When it falls in value, the option falls in value.
Significance
-
By investing in an indexed annuity, you only need to concern yourself with the upward movement of the stock market. The bond investments prevent the contract from losing money. This is significant because it represents a partial investment in the stock market without the risk inherent in equity investments. No dividends are paid on your investment in an indexed annuity, and the annuity cash value grows tax-deferred.
-
Warnings
-
Indexed annuities are complex. Because they contain embedded options contracts, there must be certain interest rate caps and participation rate caps on the product. Insurance companies control the amount of money you can earn in the contract through these caps. Additionally, these caps can be changed at the discretion of the insurer. This means that your earnings may be much lower than an actual investment in the stock market. Another disadvantage is that you will never earn the full upside potential of the stock market due to the fact that no dividends are ever paid on the contract.
Expert Insight
-
If you want to invest in an indexed annuity, make sure you invest in a contract with a low minimum interest rate guarantee. The lower the guaranteed interest rate, the higher the interest rate caps will be. The reason for this is that the guaranteed rate costs the insurer money. More money must be set aside in bonds to cover their promises. The extra cash reserve causes the insurer to cap the earnings of the contract at a lower point. With a low or no minimum guaranteed rate, you may not make any money in the contract, but you'll have higher upside potential.
Considerations
-
Consider a direct investment in the stock market though an index mutual fund or a variable annuity if you want the full upside potential of the stock market. These other investments come with significant risks but allow you to earn dividends in addition to growth in the investments.
-
