What Is a Structured Annuity and How Does It Work?

An annuity functions as a financial contract established with an insurance company, where an individual makes a lump-sum payment or a series of payments in exchange for regular disbursements, either immediately or at a future date. Structured annuities represent a specific type of deferred annuity designed to offer a balance between participating in market growth and safeguarding principal. These products aim to provide growth potential linked to an underlying market index while offering a defined level of protection against market downturns.

Core Characteristics of a Structured Annuity

Structured annuities are a specialized form of indexed annuity, also known as registered index-linked annuities (RILAs) or buffered annuities, which are issued by insurance companies. Unlike direct market investments, these annuities do not directly invest in the underlying index but rather link their performance to it. This design allows for potential gains when the market rises, while also limiting the impact of market declines. They offer a certain degree of participation in market upside, typically up to a predefined limit, and simultaneously provide a specified level of downside protection. The objective is to mitigate risk during periods of market volatility while still allowing the annuity holder to benefit from positive market movements.

Key Components and Their Function

Structured annuities are comprised of several distinct components that collectively determine their performance.

An underlying index is the specific market benchmark, such as the S&P 500 or Nasdaq 100, to which the annuity’s performance is linked.

A cap rate, also referred to as a cap, sets the maximum percentage of return an annuity holder can earn over a specified crediting period, regardless of how much the underlying index increases. For instance, if the index gains 15% but the cap rate is 10%, the credited return will be limited to 10%.

The participation rate determines the percentage of the underlying index’s gain that is credited to the annuity, after considering any applicable cap. For example, a 70% participation rate means the annuity holder receives 70% of the index’s positive return, up to the cap.

A buffer, sometimes called a shield, defines the percentage of loss the insurance company absorbs from the index’s decline before the annuity holder experiences any loss. If an annuity has a 10% buffer and the index declines by 8%, the annuity holder incurs no loss. Should the index fall by 12%, the holder would only bear the 2% loss beyond the buffer.

The floor is the minimum return an annuity can achieve, often set at zero percent. This means that even if the index’s losses exceed the buffer, the annuity’s value will not fall below a certain point, preventing further principal erosion.

The term, also known as the crediting period, is the specific duration over which the underlying index’s performance is measured to calculate the annuity’s return. Terms can vary, often ranging from one to several years, and at the end of each term, a new crediting strategy may be chosen.

How Returns Are Determined

The actual return credited to a structured annuity is calculated by applying the specific terms of its cap rate, participation rate, buffer, and floor to the performance of its underlying index.

Consider a scenario where the annuity has a 10% cap, an 80% participation rate, and a 10% buffer for a one-year term. If the index gains 8% during the term, the annuity holder would receive 80% of that gain, resulting in a 6.4% return, as this is below the 10% cap. If the index gains 15%, the return would be limited to the 10% cap, despite the higher index performance.

In a situation where the index experiences a loss, the buffer provides protection. If the index declines by 5%, which is within the 10% buffer, the annuity value would not decrease, resulting in a 0% return. However, if the index falls by 15%, exceeding the 10% buffer, the annuity holder would bear the loss beyond the buffer, resulting in a 5% loss. This mechanism protects the initial portion of losses.

Understanding Liquidity and Taxation

Structured annuities are designed as long-term financial products, primarily for retirement planning, which impacts their liquidity. When funds are withdrawn from an annuity before a specified period, typically ranging from five to ten years, the annuity holder may incur surrender charges. These fees are usually a percentage of the amount withdrawn, often starting around 7% in the first year and gradually decreasing over the surrender charge period until they reach zero.

Most annuity contracts include provisions for partial withdrawals, often allowing access to a certain percentage of the account value, such as 10%, annually without incurring surrender charges. However, any withdrawals beyond this free amount or outside the specified period are subject to the applicable fees.

Structured annuities offer tax-deferred growth, meaning that earnings accumulate without being subject to current income taxes. Taxation occurs only when funds are withdrawn from the annuity. Generally, withdrawals are taxed as ordinary income, and if taken before age 59½, they may be subject to an additional 10% federal income tax penalty, unless an exception applies.