Kerry Peabody, Long Term Care Insurance Specialist at Clark Insurance

Let’s talk a little bit more about “deferred annuities” this week, in a three part series. Here’s Part I: Indexed Annuities.

A deferred annuity is a tax-advantaged savings & growth tool. As we said before, you agree to leave a portion of your money with an insurance company, for a pre-determined period of time. In return, the company promises to pay you a minimum return. While the money grows inside the annuity, you’re not taxed on any of that growth each year, as you would be in a CD. Over time, this means that you benefit from faster growth.

Deferred annuities typically pay a higher return than CDs will. While the difference may not be huge, when you add in that your money grows tax-deferred, it can make a significant difference over time.

Usually, the longer the annuity period – the amount of time you agree to leave your money with the company – the higher your guaranteed return will be. For instance, today, 5 year annuities will guarantee anywhere from 2.15% to 3.25%, depending on the company you choose and the amount you deposit. A 10 year annuity would pay anywhere from 3.05% to 4.25% per year.

There are also annuities that give you the opportunity to make even more, by “indexing” your returns to the stock market. These are called fixed, indexed annuities. It’s important to understand that your money is not in the stock market, and it’s not subject to market risk. The carrier is taking the market risk with an indexed annuity, not you.

Here’s how a fixed, indexed annuity works: You put your money with the insurance company, but instead of a guaranteed, flat rate, you choose an “index,” such as the S&P 500. If the S&P 500 goes up, your money goes up. If the S&P 500 goes down, you’re guaranteed not to lose any of your money. So, you go up when the market goes up, but you don’t go down when the market goes down! This is the best of both worlds. “But,” you say, “this sounds too good to be true. How does the insurance company do this?” It’s actually quite simple.

An indexed annuity also has a “cap.” The cap is the maximum you can earn if the market goes up. For instance, today, you could purchase a 7 year indexed annuity with a 6.5% cap. If your index goes up this year, you’d go with it all the way to 6.5%. If it goes up more than that, you still get “just” 6.5% return. The carrier keeps anything above that. If it goes up less than 6.5% – let’s say it goes up by 4% – you’d get the full 4%. If it goes down, you don’t lose anything.

So, by “indexing” the returns, you now have the potential to make more, but you’re still protected against the dips in the market. Not a bad deal.

Most indexed annuities also offer you a fixed option, and you can usually change your allocations every year. For instance, if you feel that the upcoming year is going to be a bad year for the market, you could change to the fixed, guaranteed option, and know that you’d make a minimum return. If the next year looks better, you could switch to the index option, to take advantage of the market’s ups, without any risk of downs.

As always, you should only put money into a deferred annuity if you’re fairly confident you can leave it alone for the entire annuity period. You will be penalized if you pull it all out early, because you agreed to leave it there. Keep in mind, though, that many annuities will let you pull some money out early – often as much as 10% per year – without penalties, as part of the contract.

Next time, we’ll look a bit more closely at “immediate annuities,” and ways to use both deferred and immediate annuities to strengthen your retirement security.