Indexed Annuity Risks

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Indexed Annuity Risks

An indexed annuity is a fixed annuity whose principal is invested in one of several indices, such as the S&P 500 or the Russell 2000. Generally, it will guarantee the annuitant’s principal during the accumulation period, and may or may not provide some guaranteed minimum rate of return. Here is how it works: in any given year, if the index to which the annuity is tied has a loss for the year, the annuitant’s account will not go down in value. Instead, it will either remain at the exact dollar amount at which it began the year, or it will be credited with some nominal interest rate for the year.

Where the risk comes in

In exchange for this principal guarantee, however, the account will not be allowed to participate fully in the growth of the index. For example, if the index appreciates in value for the year, the annuitant’s account is credited with a percentage of that increase, based upon a pre-determined participation rate—say, 70 percent, which is calculated according to one of several formulas. So, if the market appreciates 12 percent in a year, the indexed annuity participant will earn 70 percent of that 12 percent. The difference is retained by the insurance company in exchange for the guarantees.

More risk

This type of annuity is very attractive to many conservative investors, but it should be understood that this capped participation, along with the possibility of multiple down years, represents a form of investment risk. If the index to which the annuity is tied repeatedly underperforms, the account value may simply sit there without growing. And in years when the index is up, the annuitant’s ability to make up for the lack of performance during those flat years is limited by the participation rate.