The SEC’s Office of Investor Education and Advocacy is issuing this bulletin to educate investors about indexed annuities, particularly those that are securities. Indexed annuities are complex products. Investors should carefully read the indexed annuity contract, and any prospectus, before deciding whether to buy the annuity.
What is an indexed annuity?
An indexed annuity is a complex financial product. It is one type of annuity contract between an investor and an insurance company. An indexed annuity generally promises to provide returns linked to the performance of a market index. There are two phases to an annuity contract – the accumulation (savings) phase and the annuity (payout) phase.
During the accumulation phase, you make either a lump sum payment or a series of payments to the insurance company. You can allocate these payments to one or more indexed investment options. The insurance company credits your account with a return that is based on the indexed investment option’s return. During the annuity phase, the insurance company makes periodic payments to you. Or, you can choose to receive your contract value in one lump sum.
Not all indexed annuities are regulated by the SEC. The SEC regulates only indexed annuities that are securities.These indexed annuities can expose investors to investment losses. If the indexed annuity is a security, generally a prospectus will be delivered to you.
Before purchasing an indexed annuity, you should ask your financial professional what type of indexed annuity it is, what risks are involved, and about any expenses such as commissions and other fees you will have to pay. You should consider asking the question, “How much of the money I invest is going to work for me and how much is going to fees and expenses?”
How does an indexed annuity work?
The amount of money (contract value) in an indexed annuity is based on positive changes, and in some cases negative changes, to a market index. This return is calculated over the course of a specified period of time. These time periods are typically twelve months long, but can vary. Before purchasing an indexed annuity, you should understand how this return is calculated and the extent to which price declines in the index can affect the performance of the indexed annuity.
Indexed annuity contracts describe both how the amount of return is calculated and what indexing method they use. Based on the contract terms and features, an insurance company may credit your indexed annuity with a lower return than the actual index’s gain. In addition, under the terms of some indexed annuities that are securities, you could lose more money in your indexed annuity when the market index goes down than is indicated by the loss of value in the index.
Indexed annuities are complex products. Before you decide to buy an indexed annuity, read the contract and, if the annuity is a security, read the prospectus. You should understand how each feature works, and what impact it and the other features may have on the annuity’s potential return.
You can lose money buying an indexed annuity. Ask your insurance agent, broker or other financial professional questions to understand how the annuity works.
How is the return calculated?
Gains. An indexed annuity generally promises to provide a return linked to the performance of an index. If the index has a gain, the contract value of your indexed annuity will also increase. But your indexed annuity may be credited with a return that is lower than the index’s return because:
- Dividends are usually excluded. Any gains in the value of the index are generally calculated without including dividends paid on the securities that make up the index. For example, a specific market index reports a total return of 7% one year, but 2.5% of those returns are from dividends. Many indexed annuities would consider 4.5% to be the index’s return when calculating any gains to your indexed annuity (7% – 2.5% = 4.5%).
- Only a portion of the performance of the index is usually included. Indexed annuities typically use one or more features that restrict the positive return that is applied to your annuity contract value. Some common indexing features include:
- Participation Rate. The participation rate determines how much of the gain in the index will be credited to your annuity. For example, if the participation rate is 75% and the index return is calculated to be 10% during the measuring period, the return credited to your annuity would be 7.5% (10% x 75% = 7.5%).
- Rate Cap. The rate cap is a maximum rate of positive return that your contract can earn. For example, if your contract has an upper limit, or cap, of 7% and the index return is calculated to be 12%, only 7% would be credited to your annuity.
- Margin/Spread/Asset or Administrative Fee. This fee subtracts a set percentage from any gain in the index. It is sometimes called the “margin,” “spread,” “asset fee,” or “administrative fee.” In the case of an annuity with a “spread” of 3%, if the index return is calculated to be 9%, the return credited to your annuity would be 6% (9% – 3% = 6%).
Some indexed annuities combine these features. For example, if an indexed annuity uses both a participation rate of 75% and a “spread” of 3% and the index return is calculated to be 10%, the return credited to your annuity would be 4.5% (10% x 75% = 7.5%; 7.5% – 3% = 4.5%).
These features can reduce your return in the same way that a direct fee would even if the annuity is called a “no fee” annuity.
Losses. Some indexed annuities, particularly those that are securities, specify that investors may lose money if the market index goes down in value. If they do, the indexed annuity may offer some limited protection against that risk. Some common protections include:
Floor. This protection limits investor exposure to a set percentage of potential loss. For example, if the floor is 10% and the index decreases by 12%, you would only lose 10% of your annuity contract value, before considering any adjustments imposed by contract terms such as surrender charges.
Buffer or Shield. This protection offers a set percentage of loss that the insurance company is willing to absorb before deducting value from the indexed annuity. For example, if the shield is 10% and the index decreases 12%, you would only lose 2% of your annuity contract value, before considering any adjustments imposed by contract terms such as surrender charges.
Indexed annuity contracts commonly allow the insurance company to change some of these features periodically, such as the rate cap. Changes can affect your return. Read your contract carefully to determine what changes the insurance company may make to your annuity.
What indexing method does the contract use?
Different indexed annuities use different indexing methods. Indexing methods determine how the change in the variable annuity’s return is determined at the end of each time period. This return is then applied to your indexed annuity, as discussed above.
Some common indexing methods include:
Point-to-point. This method compares the index level at two points in time, such as the beginning and ending dates of the time period.
Averaging. This method compares an average of the index levels at periodic intervals during the time period to the index level at the beginning of the time period.
Can you lose money buying an indexed annuity?
You can lose money buying an indexed annuity. Read your contract carefully to understand how your annuity works. You can lose money in the following ways:
Withdrawals during a time period. If you take your money out of your indexed annuity before the end of a time period, not all of the return from that time period may be applied to your annuity. In addition, you may lose some of the principal invested in indexed annuities that are securities if you withdraw amounts before the end of a time period, depending on the value of the market index at the time of the withdrawal.
Surrender charge. If you take all or part of your money out during the surrender period, you may have to pay a surrender charge. The surrender period is a set period of time that typically lasts six to ten years, or even longer, after you purchase the annuity. Surrender charges will reduce the value and the return of your investment.
Tax penalty. Under current tax law, if you take all or part of your money from tax-deferred indexed annuities before you reach the age of 59½, you may have to pay a 10 percent federal tax penalty.
Market index drop. You may lose money in indexed annuities that are securities if the market index goes down (explained above).
Insurance company risk. Many indexed annuities promise to make payments many years into the future. But remember that all amounts payable are subject to the ability of the insurance company to pay. If the insurance company experiences financial distress, it may not be able to fully meet its obligations to you.
Other Resources That May Be Helpful
- FINRA — FINRA is an independent self-regulatory organization charged with regulating the securities industry, including sellers of some indexed annuities. If you have a complaint or problem about sales practices involving indexed annuities, you should contact the District Office of FINRA nearest you. A list of FINRA District Offices is available on FINRA’s web site.
- National Association of Insurance Commissioners (NAIC) — The NAIC is the national organization of state insurance commissioners. All indexed annuities are regulated by state insurance commissions. The NAIC’s web site contains an interactive map of the United States with links to the home pages of each state insurance commissioner. You may contact your state insurance commissioner with questions or complaints about indexed annuities.