Is an Indexed Annuity Right for You?

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[155] How much of your monthly retirement paycheck do you want to be guaranteed?

That’s right. There are ways to have consistent, guaranteed sources of income in retirement. For example, an indexed annuity.

In this episode, Jeremy Keil speaks with Jeremy Lach, founder & CEO of Empire Marketing Partners, LLC, about the good, the bad, and the ugly of indexed annuities. In other words, they explain how indexed annuities can benefit your retirement and the costs associated with them, so you can make an informed decision.

They discuss:

  • How an indexed annuity works (key features and definitions)
  • Common myths about annuities
  • How to know if an indexed annuity is right for your financial situation
  • Simplified explanations for index tracking, cap rates, participation rates, and spreads (with examples)
  • How annuities help you participate in market gains without directly investing in stocks
  • And more!

What You Should Know Before Buying an Indexed Annuity

If you’re like many people, the term “annuity” might conjure up a mix of curiosity and confusion. Common myths about annuity may also give it a bad reputation for some people. In this blog, we will unpack the good, the bad, and the ugly of indexed annuities!

Follow along to delve into the core workings of indexed annuities, explore their key features, decode essential terminology, and gain valuable insights into their pros and cons.

If you know how annuities work, you’ll be better positioned to make an informed decision: Is an Indexed Annuity Right for You?

What is an Indexed Annuity?

Indexed annuities, previously known as equity-indexed annuities, are generally designed to provide a combination of guaranteed income and the potential for investment growth. They can provide some upside potential while also offering protection against market volatility.

The specific type of indexed annuity suitable for you depends on your financial needs and objectives. Understanding these priorities is crucial.

Two important questions to ask are: 1) How long do you need the annuity for? 2) Are you prioritizing growth potential or income benefits?

Who is an Indexed Annuity for?

Before answering this question, first consider: How much of your retirement income do you want to be guaranteed?

For example, you may say that you expect to spend $10,000 per month in retirement, and you would like 75% (or $7,500) of it to be guaranteed. Your Social Security and pension benefits may not be able to cover the full $7,500. In that case, having an indexed annuity as an additional source of guaranteed income can be beneficial.

As indexed annuities enable you to participate in market gains, they are also a popular choice for those seeking a balance between income security and the opportunity for modest market-linked gains. Due to the downside protection in indexed annuities, individuals with a low risk tolerance may also find them appealing.

What are Some Common Misconceptions About Indexed Annuities?

There may be several misconceptions about indexed annuities, but we would like to highlight two of them:

  1. Income Benefit vs. Cash Value: We often hear people say, “I get 6% guaranteed on this annuity” and they believe that every year, their account value is going up by 6%. Unfortunately, that’s not exactly how it works. The 6% may just be regarding the “income benefit” and not actual cash value. Annuities have separate cash value and income value accounts, and accessing the income value requires taking an income distribution. This distribution is based on actuarial models and life expectancy, and it’s important to consider how it aligns with other sources of income like Social Security.
  2. Comparisons with the stock market: Remember, indexed annuities should not be seen as an alternative to direct market investments. They are more suitable as an alternative to fixed accounts and CDs. One of the biggest misconceptions is that indexed annuities are equivalent to investing directly in the stock market. In reality, they offer market-linked returns but you’re not directly investing in the market. They come with limitations and caps (discussed below), ensuring principal protection, which differs significantly from direct stock market investments.

What are the Key Terms and Definitions I Should Know Before Buying an Annuity?

We came across an interesting article by Kiplinger, which has a list of different concepts you should know before buying an indexed annuity. They are summarized below:

  1. Index Tracking: The index tracking aspect of indexed annuities involves linking the annuity’s performance to a specific financial index, such as the S&P 500. Again, your money is not actually invested in the market. So, there are typically limitations on the maximum return, while ensuring principal protection when the index performs poorly. You also don’t get access to the dividends.
  2. Cap Rate: A cap in indexed annuities refers to the maximum amount of return an annuity holder can receive from the index. For example, if the cap is set at 5%, the annuity holder will not receive more than a 5% return, even if the index performs better. If the index performance is less than the cap rate, you’ll get the full return.
  3. Spread Rate: Spreads represent a portion of the index’s gains that are deducted from the total index performance to calculate your net gain. For example, if the index gains 10% and the spread rate is 3%, your annuity would be credited with a 7% return. Spread rates act as a fee for the insurance option.
  4. Participation Rate: These determine how much of the index’s return an investor will receive. Higher participation rates mean a larger share of the index’s growth. For instance, if the participation rate is 80% and the linked index increases by 10%, your annuity would earn an 8% return.

(Note: Generally, caps, participation rates, and spreads are not enforced simultaneously in indexed annuities. These features are distinct and may be used separately or in combination, depending on the specific annuity contract.)

Does My Advisor Get Commissions for Selling Me Indexed Annuities?

In many cases, financial advisors may receive commissions for selling you indexed annuities. The amount and structure of these commissions can vary based on the specific annuity product and the arrangement between the advisor and the insurance company. The commissions can often range from 2.5% to as high as 7%. Alternatively, advisors can also opt for fee-based indexed annuities, where they charge fees as a Registered Investment Advisor (RIA) firm. Remember, the level of commission on any contract does not determine if it is good or not!

Advisors today are encouraged by carriers to disclose their costs and commissions to clients for greater transparency and trust. So, the next time an advisor tries to sell you an annuity, ask them about their commission! If they are hesitant to share, perhaps it’s time to move on to another advisor.

To learn more about indexed annuities, check out the resources below!

If you have any questions, feel free to contact us using the contact information provided below!


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