In the 1990s, indexed annuities burst on the scene as the answer for investors who were gun-shy about variable annuities, but not satisfied with the low yields available on fixed annuities. Their appeal was heightened as the volatility of the stock market increase throughout the decade of the 2000s. And, as their popularity grew, so did the controversy surrounding them due to their complexity. As more indexed annuity products were released in the marketplace they became much more competitive, which made it increasingly difficult to find the best indexed annuities.
There are a lot of factors that need to be considered when trying to find the best indexed annuity product, and, while it is difficult to find the best of anything, there are certain indicators that can be used to narrow down the choices. The first indicators to consider are the key features that go into making indexed annuities work the way they do.
Key Features of Indexed Annuities
Stock Index Yields
Indexed annuities are, essentially, fixed yield investments much like fixed annuities, in that the annuity accounts are credited each year with a fixed rate of return. The difference is in how the yield is determined.
In a fixed annuity, the yield is based on the investment performance of the life insurer’s bond portfolio. A portion of the yield generated from the portfolio is credited to the annuity accounts. In an indexed annuity, the yield is based on the percentage gain of one of the major stock indexes.
The various indexed annuities all link to one of any number of stock indexes that track different baskets of stocks. The S & P 500 index tracks large cap and blue chip stocks which are more stable and growth oriented. There are other stock indexes that track other market segments which can offer greater upside potential, but are also more volatile. So, the best indexed annuity for you would be the one that uses a stock index that best meets your investment preference.
The percentage gains in the stock index are shared between you and the life insurer. Your share, is based on the participation rate the insurer establishes in the contract. The rate varies from one contract to another, and can be as high as 90% or as low as 25%. If the rate on your contract is 80%, then you would receive 80% of the percentage gain.
Obviously, the higher the participation rate, the better for you, however, it would be important to check the rate against two other factors: 1) How long the rate is guaranteed. If it is a “teaser” rate, it may only be good for a short period after which it can drop, and 2) How high or low the rate cap is set (discussed next). A high participation rate with a low rate cap, may not be beneficial to you in the long run.
Because the life insurer assumes all of the downside risk of indexed annuities, they limit your participation in the gain and they also limit yield that is credited to your account. Rate caps are established in the contract, and can also be adjusted. The caps can range anywhere from 15% to 4%. An 8% cap would mean that, even if the gain in the index is 20%, and, after your participation rate (i.e. 80%) is applied, your portion is 16%, your credited rate will be capped at 8%.
Again, a higher rate cap would be more beneficial to you, however, you should read the fine print to see if there are any adjustments to the cap.
Minimum Rate Guarantee
Your rate may be capped on the upside, but it is also capped on the downside, which, for many investors, is a pretty good tradeoff. Your account will never earn less than the state minimum interest rate which can range from 0% to 3%. While you should always consider products with higher minimum rate guarantees, it shouldn’t be at the expense of a higher participation rate or rate cap. A 0% rate guarantee might not be so bad if you have a higher rate cap and participation rate.
As an added layer of protection, indexed annuities include a reset mechanism which, in essence, adjusts the basis in your contract to reflect the gains achieved in the prior year. Your account value will never be adjusted down, always up.
There are several different reset methods applied by life insurers. The most favorable method is the annual reset, which applies the gains made from anniversary to anniversary. The more widely used method is “point-to-point” which applies the gains made over a multiple number of years, say, 5 years.
The great appeal of indexed annuities, for most investors, is the risk free aspect of participating in stock market gains with preservation of principal. Of course, that can only be accomplished if the life insurer who is backing your principal, and guaranteeing the minimum returns, has the financial strength and integrity to withstand even the worst economic storms.
An indexed annuity with the highest participation rate, rate cap and minimum rate guarantee would be a “fail” if the issuing life insurance company was unable to fulfill its obligations due to insolvency. While that has rarely happened (life insurers are very strictly regulated and must maintain adequate reserves), it may not be worth the sleep loss for an extra half of a percent in yield if the issuing life insurer has a questionable financial condition.
There are no perfect 10s in life. In most cases, several factors need to be rated and weighted in determining the best product for your particular needs. For instance, if your greatest concern is peace-of-mind and the financial strength of the issuing life insurer, a “10” rating for financial quality would weigh much more heavily against a “7” rating for the participation rate. The best indexed annuity is the one that rates most favorably overall based on your own criteria.