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Indexed Annuities: A Strategy to Turn Savings into Retirement Income

If you aren’t eligible for a traditional pension, you might consider whether an annuity could play a role in your retirement income strategy. Like all annuities, an indexed annuity (IA) is a contract with an insurance company that provides an income stream — either immediately or at some point in the future — in exchange for one or more premium payments.

Indexed annuities differ from other annuities in that they offer the potential to participate in market gains along with protection from downside risk. The performance of an indexed annuity is tied to a market index such as the S&P 500. When the index rises, so does the return on the annuity. But if the index tumbles, typically the worst the annuity can do is earn no interest — or a guaranteed minimum, if one is offered. The guaranteed minimum (typically an annual rate of 1% to 3%) is contingent on holding the indexed annuity until the end of the term.

Indexed annuities are complex products with rules, restrictions, and expenses, and they are not appropriate for everyone. It may be helpful to understand the following terms when you are considering your investment options.

16% of U.S. workers expect annuities to be a major source of retirement income, 37% minor source, 46% no source

Calculating Return Rates

The participation rate determines how much of the index gain will be credited to the annuity. A participation rate of 80% means the annuity would be credited with only 80% of the gain experienced by the index.

A spread/margin/asset fee may be assessed in addition to, or instead of, a participation rate. If the index gained 7% and the spread/margin/asset fee was 2.5%, then the gain in the annuity would be 4.5%.

The interest-rate cap is the maximum rate of interest the annuity will earn, regardless of how much the index gains.

Index performance generally does not include dividends. Participation rates, cap rates, and other fees are set by the insurance company. Some companies may change these provisions either annually or at the start of each contract term, which could affect the investment return.

Measuring Index Performance

The way in which index performance is measured may vary, depending on the contract, and could make a significant difference in the growth of the annuity.

Annual reset (rachet). Compares the change in the index from the beginning to the end of each year, “locking in” an investor’s gain. Any declines are ignored.

Point-to-point. Compares the change in the index at two discrete points in time, such as the beginning and ending dates of the contract term. Because this method relies on a single point in time (i.e., the last day of the contract), a large decline in the index prior to that point may decrease the interest.

High water mark. Compares the index value at the beginning of the contract to its highest value at various points during the contract (often anniversaries of the purchase date). This method may lead to a higher interest rate than other indexing methods. However, because interest is not credited until the end of the term, there may be no index-linked gain if the annuity is surrendered early.

Surrender charges are often imposed if an annuity is surrendered during the early years of the contract, but some indexed annuities allow withdrawals of up to 10% per year without surrender charges. Withdrawals will reduce the principal, and withdrawals before the end of an index period will receive no interest for that period. Early withdrawals prior to age 59½ may be subject to a 10% federal income tax penalty.

The performance of an unmanaged index is not indicative of the performance of any specific investment. Individuals cannot invest directly in an index. Any annuity guarantees are contingent on the financial strength and claims-paying ability of the issuing insurance company. Depending on the guarantees, it may be possible to lose money. Be sure to review the contract carefully before deciding whether to invest.

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Securities offered through Equitable Advisors, LLC (NY, NY 212-314-4600), member FINRA, SIPC. Annuity and insurance products offered through Equitable Network, LLC and its subsidiaries.

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