An annuity is a contract between the buyer of the annuity, called an annuitant, and an insurance company, called the guarantor. The annuitant deposits a sum of money with the guarantor and in return, receives installment payments either for a fixed period of time or for the life of the annuitant. An indexed annuity means the performance of the annuity is tied to the performance of a particular index, such as a bond index or the stock market. An indexed annuity permits the investor to participate in, and potentially benefit from, general market changes, but it does have its share of disadvantages.
A surrender period refers to the amount of time an investor must wait before he may withdraw deposited funds from an indexed annuity, or cash it in. This is significant because surrender periods may run from five years and up, depending upon the annuity contract. If the annuity is sold or if funds are withdrawn prior to the expiration of the surrender period, the annuitant must pay a surrender charge, also called a surrender fee. The amount of this fee varies, but it can run as high as 20 percent. The fee is often deducted from the amount withdrawn from the annuity at the time the withdrawal is made.
An indexed annuity is tied to the performance of a particular index. As such, the better the performance of that particular index, the greater the return on the annuity investment. Indexed annuities often have a minimum that the investor will receive and the investor's losses will not fall below that floor. On the flip side, guarantors often include caps on indexed annuities as well. This limits the amount of gain the investor can receive as a result of a high-performing index. Some guarantors only give investors a set portion of the market's overall return, and many exclude the payment of dividends altogether.
Annuities in general are very complicated products, and indexed annuities are no exception. The prospectus, which is a legally mandated document that discloses the essential information related to the purchase of a security, can be dozens of pages long and written in a form of legalese that can make it hard to understand. Investors should read all prospectus information and ask for clarification of anything that is unclear. The best time to seek this clarification is prior to purchasing an indexed annuity.
Indexed annuities are professionally managed products. The management of these products comes at a cost. Management fees are charged to the annuity and reduce the return the investor receives on the product. In addition, withdrawals made from an indexed annuity by the annuity owner under the age of 59 1/2 are subject to a 10 percent penalty fee. The guarantor may also impose an additional fee if excessive or multiple withdrawals are made from the annuity prior to the maturity date. The annuity contract defines how many withdrawals are considered excessive.
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