Index Annuities are generally tax-deferred contracts tied to an equity index such as the S&P 500. They are sometimes referred to as equity-indexed annuities. An index annuity typically carries a guaranteed rate of interest between 1% and 3% if it is held until the end of the surrender period.
Index annuities are generally contracts between the annuitant and either an insurance company. The returns realized with indexed annuities is typically greater than that of bonds, CD’s, and money market accounts. However, they are not as great as stock market returns. One thing that you want to be aware of is that the guarantee of an indexed annuity are underwritten by the issuer. This means that if the (life) insurance company fails, this guarantee is worthless.
Functions of indexed annuities
Indexed annuities are basically an investment option and provide the investor with guaranteed gains and minimal levels of risk. There are 3 basic characteristics of this type of annuity:
Periodic payments or lump sum
One of the better functions of indexed annuities is the payment option. You can choose to have periodic payments (usually monthly) so as to replace your income or supplement your retirement income. However, most individuals contribute into this type of annuity throughout their working lives. Usually, there is a minimum investment made up front, and then further contributions can be made.An other payment option is the so-called lump sum option wherein the payout is made with only one payment. You purchase an indexed annuity with a lump sum. Most individuals who have saved money over their working years will invest in the annuity once they reach retirement age. Unfortunately, this can involve giving the annuity or insurance company hundreds or thousands of dollars all at one time.
The benefit of indexed annuities is that they do not necessarily involve full exposure to the stock market. As a result the exposure to the risk of loss of principal is limited. Independent of the stock market there is a guaranteed minimum that you will earn while there is still a level of safety that is offered when investing in indexed annuities compared to investing in the stock market.
Earnings potential are somewhat limited with these types of annuities. Even tough the value of the stock market may increase, an earnings caps may limit the potential of earnings. For example, if the earnings cap of an indexed annuity is 7% and the financial index earns twice that, you will only realize 7% earnings.
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