Life Insurance Annuity – How do indexed annuities work?

As a former Certified Financial Planner, I used to get a lot of questions about life insurance annuities, specifically Indexed Annuities, how they work, and what they actually invest in.  I’m a firm believer that everyone’s situation is different, and many financial vehicles that don’t fit one particular situation, may be exactly the right thing for another.  Case in point; I had a wealthy client who wanted to make sure no matter what, his principal was protected.  He already had adequate exposure to stocks, bonds, real estate, and some other financial vehicles, so he’s one of those rare clients that we decided to use a life insurance annuity known as an indexed annuity.  To make a long story short, during the downturn in the early 2000’s when many of his other financial vehicles where losing, his life insurance annuity was protecting his principal and doing it’s job.  Whereas one of his stockbrokers was telling him not to buy an indexed annuity before the downturn, my client was certainly glad he did since this account was the only one at that point that wasn’t losing money.  Let’s explore for a moment just what these life insurance annuity companies invest in:

As you may know, an indexed annuity offers limited upside potential of a particular market index without downside market risk.  This basically means that the underlying life insurance annuity company guarantees your principal AND gives you part of that index’s return.  Generally, there are three components involved with premiums that are invested in indexed annuities.  First of all, fixed rate investments such as bonds are used to provide the long term guarantees promised by the contract.  Therefore, on a $100,000 premium with fixed interest rates of 7% during the term of the contract, $93,000 would be needed to satisfy the contractual guarantees at the end of the contract term (assuming the only guarantee was that of principal).  Operating expenses and profit margin of the insurance company make up the second component.  If these costs represent 2% then an additional $2,000 of the premium would be used for this purpose.  In this example there would be $5,000 remaining for the last component.  Normally, this money would be used to purchase call options to support the growth in the underlying index.  The price of these options will affect the participation rates and/or margin/spread that the life insurance annuity company can offer.  Sounds complicated?  It is!  However, this should give you a general overview of the mechanics of an indexed annuity.  Enjoy Life!

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