Annuities come in two types: fixed and variable. A fixed annuity provides the investor with a guaranteed fixed rate of return for the specified time of the annuity. While there is comfort in having a fixed return, there is also no opportunity for the investment to grow in value. The rate can change, but it will never go below the minimum guaranteed rate.
A variable annuity, on the other hand, invests the purchaser’s money into a group of mutual funds, which can include stocks, bonds and money market accounts. The value of the annuity, therefore, adjusts with changes in the various markets.
An indexed variable annuity is a hybrid of a fixed and a variable annuity. It offers a guaranteed minimum rate of return, while at the same time, provides the opportunity for the capital investment to appreciate with rising markets. An indexed variable annuity invests its funds into a market index, such as the S&P500 Composite Stock Index.
Pros
Like other annuities, the earned income in an indexed variable annuity is tax-deferred. The investor does not pay any taxes until the withdrawal period starts.
Payments are usually guaranteed for a specified time period. However, the annuitant can elect to receive payments for his entire life and/or also for the lifetime of his spouse.
The indexed variable annuity provides some protection against inflation since the funds are invested in a market index. The value of the annuity increases with a rise in the stock market index.
While the amount of money that can be put into an IRA or 401k plan is limited, an investor can put unlimited amounts into an annuity. The best strategy is to invest the maximum into your IRA or 401k first before starting to invest in annuities.
Cons
While the value of an indexed variable annuity rises when the index goes up, most of these types of annuities have caps that limit the maximum appreciation. This means that if the market goes up substantially, the investor may not fully participate in the rise. Conversely, the minimum guaranteed rate assures the investor that he will receive at least a minimal return. Indexed variable annuities also do not receive dividends since they are invested in an index and not the actual stocks.
Even though the income on an indexed variable annuity is tax-deferred and not taxed until withdrawal, it is taxed at higher ordinary income rates rather than the capital gains rate, which has historically been lower. Each investor has to make his own calculations regarding his future tax rate to determine if it is better to invest in an annuity or put the funds directly into a mutual fund.
Annuities are intended to be long-term investments, and insurance companies impose severe fees for any early withdrawal of funds. Generally, the surrender fee for a withdrawal in the first year of the annuity could be as much as 7 to 10 percent. The fees will scale down as the annuity ages.
Risk
An indexed variable annuity is not guaranteed by any government agency. The probability of the annuitant receiving the agreed future payments from the insurance company depends on the financial strength of the issuer. An investor should check the rating of the insurance company with rating agencies like Moody’s, A.M.Best and Fitch.
Most states do have laws that protect the annuitant in the event that the insurance company goes out of business and cannot repay the annuity. States have funds to protect the investor in amounts ranging from $100,000 to $500,000 (as of 2010). The investor should check with his state agency to determine the amount of coverage for his state.
Indexed variable annuities are not considered securities and are not regulated by the SEC. An investor must conduct his own due diligence to determine the value and legitimacy of the offering.
Investor Suitability
An investor should only purchase an indexed variable annuity after he has put the maximum amount of funds into an IRA or 401k.
While the investment in a variable annuity can go up, it can also decrease. An investor must be prepared to assume this risk.
The investor must be prepared to keep the annuity long enough to get around the surrender fees in the unfortunate event that he should need funds for an emergency.