Index annuities are savings instruments especially well-suited as retirement accounts. The biggest index annuity investment mistake is not is not understanding their design. Investing money you need to make ends meet will increase the likelihood of early withdrawals, along with associated penalties.
Index annuities feature vesting schedules similar to that of 401(k) employer matching. You're allowed to withdrawal a certain amount penalty-free, but earnings on the withdrawn amount are reduced. This structure discourages investors from bailing on the insurance company during bear markets. In short, don’t invest in an index annuity if you’re uncomfortable with its vesting schedule.
You should not be investing in any type of annuity prior to the age of 30. This goes back the core theme of annuities being retirement savings vehicles. Just like a 401(k) or IRA, an index annuity comes with disincentives for pre-retirement withdrawals.
In the case of annuities, the IRS assesses a 10% tax penalty on income withdrawals prior to the age of 59.5. The only way to avoid the 10% deduction is by waiting until retirement to start making withdrawals. If you have no intention of waiting, consider alternative investments like CDs or mutual funds.
The single most important factor of an index annuity contract is the participation rate — the portion of raw index growth that gets credited to your account. The higher this rate, the higher the effective annual yield. Participation rates vary from contract to contract, typically ranging from 20%-100%.
A rate of 20% is rather low and only advisable if the contract compensates with zero cap, a lenient vesting schedule, high minimum rate, or zero administrative costs.
Although a 20% participation can be favorable given other factors, don’t over-prioritize no-cap or high minimum rates. Because index annuities provide the greatest yield during years of moderate positive market growth, strive to capitalize on the average; leave the peaks and valleys for the insurance company.
Many index annuities cut off earning after a certain percentage. This contract provision is known as the "cap rate". Caps determine the maximum amount of growth your account can experience in a given year. Insurance companies used caps to counterbalance poor years with the tops of extremely good ones.
A common pitfall when shopping for index annuities is either getting stuck with a very low cap, or sacrificing more important factors (like participation rate) for an excessively high cap.
Read your contract carefully. Look for written guarantees on important provisions like the participation rate, minimum rate, and cap rate. Be wary of enticing introductory rates. Don’t assume that a 90% participation lasts for the full contract term unless it’s explicitly spelled out. In fact, a rate that high typically won’t.
When looking at two similar index annuities, compare apples to apples. For instance, a contract with a full-term guaranteed 70% participation is actually preferable to a 90% rate that’s only guaranteed for the first year. A partially-guaranteed rate isn’t a deal-breaker as long as the rate has a reasonable floor after the guarantee expires. Avoid contracts without floors.
Understand exactly how your annuity calculates annual yield before signing the contract. As a rule of thumb, the insurance company credits an index annuity account per annum. This is different from a mutual fund or variable annuity, which can grow on a daily basis. With index annuities, as the anniversary date approaches, the insurance company will use one of two common ways to calculate the annual yield: 1) year-to-date, or 2) yearly average.
A year-to-date calculation simply takes the value of the S&P 500 (or whatever the index may be) at the pervious anniversary date and subtracts it from the current. The percent difference equals the gross annual yield. Notice how the S&P’s ups and downs between these dates are irrelevant.
A yearly average calculation averages out the performance of the S&P 500 the anniversary dates. The gross annual yield equals monthly performance / 12. Notice that averaging reflects the month-to-month fluctuations of the index.
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