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INDEXED ANNUITY – HYPOTHETICAL EXAMPLE

Note, like on the current page the calculator below is a screen shot and not a working calculator:

A Hypothetical example:

By walking through this hypothetical example, you will be able to estimate the amount of growth on an indexed annuity, as well as how that figure is derived.

The first step involves calculating the overall growth on the indexed annuity. We will keep the parameters fairly basic by using $100,000 as the “starting principle”. A 50 year old investor might expect to need to begin taking withdrawals at age 70, so we will enter 20 years in the “growth period”.

Assessing the expected growth can be tricky. Indexed annuities’ rates of return are determined using one or several crediting methods. Each method is applied to the underlying index that is being tracked. Therefore, in order to obtain a better idea of the annuity's total overall return, you will need to determine the appropriate limits for a specific product and crediting method.

In this case, let's assume the annuity is tied to the S&P 500 Index. Over the last 20 years, the S&P 500 has returned an average of 8.2% per year 1. Below are a few examples of crediting methods:

  • Cap Rate - If the annuity has a cap, it will limit the amount of growth that you can attain based on the underlying market performance. For example, if the S&P 500 index performed at 8.2% in a given year, and your annuity has a cap rate of 3%, then your gains in that time period would be "capped" at 3%. Enter 3% into the “annual growth rate” of the calculator inputs.
  • Participation Rate - If the annuity uses a participation rate, it will allow its holder to "participate" in only a percentage of the gains achieved by the underlying index. For example, if the participation rate is 70%, then the annuity holder would only be able to attain 70% of the underlying index return in the given time period. In the “annual growth rate” you would enter 70% of 8.2% in this S&P 500 example, or 5.74%.
  • Spread - If the annuity uses a spread, it will subtract a certain percentage from any gain that the underlying index achieves. For example, if the annuity has a spread of 5%, and the S&P 500 increases 8.2%, then the annuity holder would earn 3.2%. To simulate this spread, we would put 3.2% as the “annual growth rate”.

Note that many annuities may combine multiple crediting limitations on a single contract, for example, 90% participation AND a cap of 4%. In these situations, the cap is usually applied last, so a 10% index return with a 90% participation rate yields 9%, but is then capped at 4%. By entering only the cap, our outputs will illustrate the maximum expected return of this hypothetical indexed annuity. It’s possible under poor market conditions that the returns of an actual indexed annuity could be as low as 0%.

We know this can be confusing and have helped hundreds of annuity owners understand their contracts. For help, contact one of our investment professionals from the Contact Us page.

The base contract for indexed annuities typically has no explicit fees. Therefore, in the “expense rate”, we would enter 0%. Although it’s important to note that additional costs may apply for optional living benefits or death benefits called riders.

By also entering 0 into the “withdrawal period” and “annual growth rate during withdrawal period” we can ignore the income aspect of the indexed annuity and just focus on growth expectations.

Once you have clicked on the Calculate button, the following information will appear showing the total amount of growth the annuity achieved over the 20 year time frame.

Here, you will notice not only the amount of gross total gains on the annuity, but also that there have not been any explicit fees (important note: optional income riders attached to any contract typically come with a separate annual fee, often around 1% per year).

Once you have factored in the annuity's crediting method, you will now have the total return on your index annuity throughout its accumulation period and the ending dollar amount. It’s this ending dollar amount that you will use for income generation from the annuity going forward.

In this example, the annuity would have returned about $80,611 in gains, versus a hypothetical market return of $383,666 based on recent averages . One investment is not inherently better than the other, provided you have appropriate expectations and do not need growth to achieve your long-term financial objectives. For an investor that does need growth in order to sustain purchasing power throughout retirement, consider the impact of caps and other return limiters carefully.

It is important to note that index annuities can be highly complex financial vehicles with many moving parts, so it essential to understand how these products work and where they could fit into your overall financial plan. With this in mind, before you purchase an annuity you should ensure it’s the right product for you.

1 Thomson Reuters, S&P 500 Total Return 12/31/1992 to 12/31/2012, inclusive of dividends and interest.
2 ibid

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