Where the money goes
An indexed contract is an agreement with an insurance company: an indexed universal life policy, or a fixed indexed contract built for retirement income. You pay premiums from income or savings, or for some retirement contracts from a rollover; the carrier holds the money in its general account, backed mostly by bonds, and the contract states that index losses aren't credited against the contract value. Surrender charges, rider fees and, on a life policy, the cost of insurance can still reduce it. Interest is credited to your contract based on the movement of an index, most often the S&P 500, but you don't own the index and the money never goes into stocks.
How the interest is figured
The most common method is annual point-to-point: the carrier compares the index on your contract anniversary with the index a year earlier.
- If the index rose, you're credited the gain up to a cap (say 8%), or a share of it set by a participation rate (say 60% of the gain), sometimes minus a spread.
- If the index fell, you're credited 0%. The market doesn't reduce your contract value or prior credits, though rider fees and withdrawals can.
- The new value becomes the base for the next year. Gains lock in; losses don't accumulate.
| Index year | Credited, with an 8% cap |
|---|---|
| +15% | +8% |
| +5% | +5% |
| −20% | 0% |
| +12% | +8% |
Caps and participation rates are set by the carrier for each term and can change at renewal within limits stated in the contract. A high cap today isn't a promise about next year; the guaranteed minimums are.
The four things in the fine print
- Surrender period and charges: usually 5 to 10 years, with a charge that declines each year on withdrawals above the allowance. This is the price of the guarantee.
- Free-withdrawal allowance: retirement contracts commonly allow 10% of the contract value each year without a surrender charge, after the first year. Life policies use withdrawals and policy loans instead, each with its own rules.
- Riders: a lifetime-income or enhanced death-benefit rider adds a guarantee and usually a fee of about 1% a year. Worth it for some, not for all.
- The carrier: the guarantees depend on the claims-paying ability of the company behind them. Agents look at financial-strength ratings from AM Best and others.
Taxes
Interest grows tax-deferred. A retirement contract can usually take money from a 401(k) or IRA as a direct transfer without tax. Withdrawals of gains from it are taxed as ordinary income, and withdrawals before age 59½ may carry a 10% federal penalty on top. Required minimum distributions still apply to money that came from a retirement account. Life policies follow different tax rules, which the agent walks through before anything is signed.