What is the Greatest Disadvantage of an Equity-Indexed Annuity?
An indexed annuity allows its owner to reap a percentage of gains associated with its index; however, its contract specification usually specifies some restrictions and limitations.
These restrictions come in the form of caps and floors, which could impede your ability to expand your investment portfolio.
Equity-indexed annuities can be valuable components of retirement portfolios, but they do come with fees. Surrender charges tend to be high and early withdrawal penalties of 10% may apply if funds are withdrawn before reaching age 59 1/2.
Equity-indexed annuities come with several fees associated with their indexing formula and participation rate of the insurance provider, which determine how much additional interest will be added onto annuity contracts on contract anniversary dates.
Index-linked annuities usually include a “buffer or shield,” which establishes a loss percentage that the insurance company is willing to absorb before deducting value from your contract. This protects against losses but limits profit generated when its index it tied to increases, so it is crucial that you fully comprehend these limitations prior to investing in an equity-indexed annuity; to do this effectively it’s wise to consult a qualified financial professional as they can guide you toward selecting one tailored to meet your individual circumstances.
2. Performance Caps
Growth without loss is the holy grail of investing, and equity-indexed annuities often represent this promise. Unfortunately, however, they cannot meet this objective without experiencing some short-term volatility associated with market exposure.
Index annuities may offer annual caps on index-related gains as well as protection from account value losses; in turn, participation rates and fees could further limit potential returns.
Example: If an index offers maximum return rates of 10% but your annuity has participation rates and spread rates of only 3%, its total return would only amount to 8% (9% minus 3% = 8). Other fees such as cap rates, participation rates, spreads and asset or administrative fees also reduce potential returns significantly.
3. Surrender Charges
An equity-indexed annuity may allow you to take advantage of some of the growth in a stock market index; however, its contract specifications could restrict your potential upside and/or recover from losses. These features include participation rates, caps, spread or margin fees (subtracted from gains) and other restrictions that limit potential upside and/or recover from losses.
Some indexed annuities offer additional protection with buffer or shield features that reduce how much loss is deducted from your annuity each time it takes a hit. While this may help limit short-term losses, it comes with its own set of drawbacks.
Indexed annuities are designed for long-term investments, and any withdrawals within six to ten years could incur surrender charges and tax penalties, which could reduce both returns and principal investment significantly. Furthermore, tax-deferred annuities convert capital gains that would normally be tax-efficient into regular income that has higher taxes; this can further decrease returns while potentially forfeiting funds already deposited to your account.
Indexed annuities offer investors protection from market downturns while still preserving long-term appreciation potential. Most indexed annuities feature something called a participation rate that indicates how much index growth contributes to contract value over time, while many include an index loss buffer to prevent insurance companies from decreasing your participation rate in response to index losses.
Swedroe points out that indexed annuities do not typically consider reinvested dividends when calculating index gains, even though these could account for up to 40% of market returns. Furthermore, most annuities contain steep surrender charges which reduce returns over a set period.
Even with their shortcomings, indexed annuities offer numerous advantages despite these drawbacks, including deferring all gains until retirement when withdrawing them, limited downside protection during market declines, and potentially higher potential returns than fixed-rate annuities, bonds or certificates of deposit. Furthermore, annuities can be guaranteed for life and payouts passed directly onto beneficiaries without going through probate court.