A Primer on Registered Index-Linked Annuities
Amid choppy financial markets in 2022, investors increasingly discovered the value of annuities. While much of last year’s annuity sales were in fixed-rate deferred annuities, index-linked annuities continued to post strong sales, rising to almost $41 billion in 2022—6% higher than 2021 and a new all-time sales record.
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A Primer on Registered Index-Linked Annuities
Amid choppy financial markets in 2022, investors increasingly discovered the value of annuities. While much of last year’s annuity sales were in fixed-rate deferred annuities, index-linked annuities continued to post strong sales, rising to almost $41 billion in 2022—6% higher than 2021 and a new all-time sales record.1
As investors and financial professionals consider implementing index-linked annuities in their retirement plan strategies, it’s essential to understand how they work and their relative advantages and disadvantages.
What is a Registered Index-Linked Annuity?
Index-linked annuities are a deferred annuity whose interest payments are linked to a stock market index (e.g., S&P 500). The index-linked annuity is an insurance contract and does not represent ownership of any stock or index. An index-linked annuity may lose value.
How Does a Registered Index-Linked Annuity Work?
Index-linked annuities have the characteristics of both a variable and fixed-rate annuity, in which they offer a minimum guaranteed interest rate in combination with a variable return linked to an equity market index. This “hybrid” approach means less market risk than a variable annuity and the potential to earn higher returns than a fixed-rate annuity.
The guaranteed interest rate typically ranges from 1-3% and is paid on at least 87.5% of the principal premium invested. There may be early surrender fees and a 10% tax penalty for early withdrawals.
How is the Interest Rate Calculated?
Not all index-linked annuities pay interest using the same methodology, so it’s important to understand how an annuity computes the interest rate it pays. Here are some general approaches used:
- Participation Rate—This rate governs how much of an index’s gain will be credited to the annuity holder. For instance, if the annuity’s participation rate is 80% and the index to which it’s linked rises 10%, then the interest rate credited is 8%.
- Spread/Margin/Asset Fee—This fee may be used in place of or in addition to a Participation Rate. This fee (e.g., 3%) will be subtracted from the gain in the index.
- Interest Rate Cap—Some index-linked annuities place a ceiling on the interest rate that will be paid. For instance, if the interest rate cap is 15% and the index gain is 20%, the annuity holder will only receive a 15% interest credit.
There are several ways insurance companies calculate the change in the index. For instance, a gain may be calculated using an annual calendar-year reset, calculating the gain from the index’s high water mark, or point-to-point (e.g., beginning and end of contract). Each has its own set of advantages and disadvantages, so it’s essential buyers understand them.
In the case of index losses, a “buffer” level—which is selected by the purchaser—will provide some downside protection. For example, if a buffer of -10% is selected, the insurance company will absorb losses up to -10%. Index losses will reduce the account value when the negative index return exceeds the buffer percentage.
Index-linked annuities are complex instruments, but may be beneficial to individuals seeking higher returns than prevailing fixed-rate investments (e.g., bonds or CDs) and without the risk of a direct investment in the stock market. Individuals may discover working with a financial professional to find the most appropriate annuity to be invaluable.
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Please reference disclosures at: https://blog.americanportfolios.com/disclosures/
