 Personal Finance PowerPoint presentation, indexed annuity. Prepare to get financially fit by practicing personal finance. Most of this information can be found at Investopedia Indexed Annuity, which you can find online. Take a look at the references, resources, continue your research from there. This is by Julia Kagan, updated February 28, 2021. In prior presentations, we looked at insurance in general. We then moved to the life insurance. Now we're talking about different kinds of annuities. In that context, we're asking the question, what is an indexed annuity? An indexed annuity is a type of annuity contract that pays an interest rate based on the performance of a specified market index such as the S&P 500. So thinking about annuities in general, we're usually taking a lump sum, and we're giving that to something like an insurance company in exchange for a series of payments that are going to be in some format happening in the future, possibly doing this in alignment or in conjunction or as part of our retirement planning strategy. So by doing this, we're hoping that we can stretch out that money a little bit further, but also noting that we're going to have restrictions when we do that because it's going to be under the annuity. Whereas if we were to invest somewhere else, like simply just stocks and bonds, we would have more easy access to like the principle of it when we have an annuity. We're kind of locked in to the contract of the annuity for the series of payments into the future. Now, in order to get possibly a higher or exposure to a higher possible rate of return on the annuity, they can try to connect it or index it to something like the S&P 500, which is in and of itself basically an index fund. So when you think about the market in general, how we measure the markets, they might take certain indexes, which are kind of averages, and those are going to be an index fund so they can kind of try to tie the performance of the annuity to the index fund, which gives possibly more upside potential, but also more kind of downside potential because now you've got market exposure involved, which adds more risk, but possibly more potential for gain. So it differs from fixed annuities, which pay a fixed rate of interest and variable annuities, which base their interest rate on a portfolio of securities chosen by the annuity owner. So a fixed rate annuity is probably the most conservative kind of annuity because everything, and that is to the most part kind of laid out up front so you know exactly what's going to happen. You don't have that same kind of market exposure that you would have if you're going to have some kind of investment type of item. The variable annuity based the interest rate on the portfolio of securities chosen by the annuity owner, so that gives a little bit more flexibility in terms of what your kind of portfolio you're trying to tie the annuity to. Instead of doing that, you're picking something like the S&P 500, which is kind of an index that measures kind of market performance as a whole more of a generic kind of measurement of market performance, for example, using an index. So index annuities are sometimes referred to as equity index or fixed index annuities. Now index annuities work. Indexed annuities offer their owners or annuitants the opportunity to earn higher yields than fixed annuities when the financial markets perform well. So that's great that you can get those higher returns possibly, but at the same time you want to look at it in alignment with your overall investment strategy. You might be setting up the annuity, for example, to have a very dependable cash flow stream in the future. So the fixed annuities are going to be quite dependable typically because everything is laid out up front. Once you have more market exposure, then you're taking on more risk as well. So that lowers the amount of kind of dependability, but also comes along with possible higher potential for gain with it. So typically, they also provide some protection against market declines. So that's going to be important as well, because again, you're setting this up most likely for a dependable stream of income. So you're going to want to be saying, well, what will happen? Are there any safeguards in the event that the market goes down? The rate of an index annuity is calculated based on the year-over-year gain in the index or its average monthly gain over a 12-month period. So you can track basically the index and kind of figure out how they're tying their return to the index. While index annuities are linked to the performance of a specified index, the annuitant won't necessarily reap the full benefit of any rise in that index. One reason is that index annuities often set limits on the potential gain at a certain percentage commonly referred to as the quote, participation rate end quote. So you're basically not invested directly in the index. In other words, you could go to the actual index and say put a Vanguard account or an eTrade account or something and possibly invest in that particular index where you'd be invested in it. You're invested in an annuity that's kind of tied to the index. So it could have some restrictions in terms of how high it would bump up if there were potential gains and how low possibly it would go for potential losses, which could have its goods and its pros and its cons, right, because that could give you some more security even though you have some more ability to get to the upside. It might have some more security in terms of the downside too, so that would be the idea. So the participation rate can be as high as 100%, meaning the account is credited with all of the gain or as low as 25%. Most index annuities offer a participation rate between 80% and 90%, at least in the early years of the contract. If the stock index gained 15%, for example, an 80% participation translates to a credited yield of 12%. Many index annuities offer a high participation rate for the first year or two after which the rate just adjusts downward. Yield and rate caps. Most indexed annuity contracts also include a yield or rate cap that can further limit the amount that's credited to the accumulation account. A 7% rate cap, for example, limits the credited yield to 7%, no matter how much the stock index has gained. Rate caps typically range from a high of 15% to as low as 4% and are subject to change. In the example above, the 15% gain reduced by an 80% participation rate to 12% would be further reduced to 7% if the annuity contract specifies a 7% rate cap. And that doesn't sound good, but obviously you might have this cap or a limited gain or a bottom line on this as well. So in years when the stock index declines, what happens in declining years, the insurance company credits the account with a minimum rate of return. So if the index declines, you may have the minimum rate of return and that's the bottom side of things, which could be a benefit. So a typical minimum guarantee is about 2%. So some can be as low as 0% or as high as 3%. Adjusted values at specific intervals, the insurer will adjust the value of the account to include any gain that occurred in that time frame. The principal, which the insurer guarantees, never declines in value unless the account owner takes a withdrawal. So that is quite nice, right? So your principal is there and that's not something that you basically have. You might be saying, well, why don't I put the money directly into the stock market, which you could and there's clearly frozen cons to it, right? Because if you put the money into the stock market tied to the same kind of index, then you would put your principal in there and whatever gains you had, you wouldn't have this limiting kind of thing on your gains. But of course you could have losses like the market could go down and you could end up with less money than you originally put in there. Obviously the other benefit of putting the money directly into the stock market is that if it's not under the umbrella of an IRA or anything like that, you also have access to the principal, whereas you don't have access to the principal as easily if it's in an annuity kind of contract because you've given it, you've promised kind of the money over in exchange for the series of payments that will happen in accordance to whatever kind of setup you have set up with the insurance company. So the principal, which the insurer guarantees, never declines in the value unless the account owner takes a withdrawal. Insurers use several different methods to adjust the account's value such as a year-over-year reset or a point-to-point reset which incorporates two or more years worth of returns. As with other types of annuities, the owner can begin receiving regular income by anutizing the contract and directing the insurer to start the payment.