Smart Annuity

What Are Indexed Annuities?

Kiplinger's Personal Finance discussed a few pros and cons about indexed annuities. In short, you need to study the fine prints and make sure you understand what you are about to buy. Like elsewhere in the spectrum of investments, there is no free lunch.

An equity-indexed annuity is a type of deferred fixed annuity, which provides investors with a guaranteed minimum return while allowing them to save for retirement on a tax-deferred basis. What distinguishes the equity-indexed annuity from the traditional annuity is that its returns are partially linked to stock market indexes, usually the Standard & Poor's 500-stock index.

But investors who believe that these annuities will match stock market returns in a bull market will be sorely disappointed. The index-linked return is based on a formula described in the insurance contract. The "participation rate" determines what percentage of the gain in the stock market index will be credited to your annuity. For example, if the participation rate is 80% and the index increases by 8%, the interest credited to your annuity will be 6.4%.

Other calculations will also gnaw at your return. For instance, most annuities exclude the value of dividends from the gains in the index. And some impose a monthly or yearly cap on your return, no matter how well the market does. What's more, insurers can charge an asset fee, which ranges from 2% to 2.5%.