An insurance company issues an index annuity contract and guarantees that as long as you own the contract and abide by its rules, you can’t lose money. When the stock market goes down, you lose nothing. When the stock market goes up, you reap about half the gains. Sounds reasonable, right? But how does it work?
When you hand over a chunk of your money to the insurance company that issues your index annuity, the carrier uses your money for three purposes. It puts a good bit of the money in bonds, which earns interest. It also deducts a small amount for its own expenses. And finally, it uses the rest of the money to buy index options.
So what is an index? And what are options? A market index is a scale that reflects the average price of a particular group of stocks or bonds. The Dow Jones Industrial Average, the oldest and most famous market index, is based on an average of the prices of 30 of the largest U.S. companies. Other indexes represent the average prices of the European stocks, Asian stocks, oil company stocks, and so on. The index most widely used by investors is the Standard & Poor’s 500 Index, an average of the prices of the 500 largest U.S. companies.
Options are the right, but not the obligation, to buy or sell something. For example, suppose a trucking company pays $500 for the option to buy 10,000 gallons of gas next year at $3.50 per gallon. If the price of gas rises to $4 per gallon, the $500 option will be worth $5,000, and you could sell it for that amount. That’s because the company owns the right to buy 10,000 gallons of gas for $35,000 (at $3.50 per gallon) and sell it for $40,000. If they sell the option, the profit will be $4,500 ($5,000 minus the $500 you pay for the option).
When insurance companies buy index options, they do virtually the same thing. But instead of profiting from a rise in the price of gas, they profit from an increase in the average prices of certain groups of stocks, as measured by a market index, usually the S&P 500. If the S&P goes up, the buyers of index options can multiply their investment. And if the S&P drops, they let their option expire unused and they will lose their small original investment to buy the option.
To sum it up, the insurance company makes money when the index goes up and loses very little when the index goes down. This allows it to keep its promise to the buyer of the annuity. It also allows the insurance company to pay the annuity owner a portion of the index gain in years when the index goes up and nothing in the years it went down. If the index never goes up during the entire life of the index annuity contract, the annuity owner will not lose anything and they will still earn a guaranteed minimum interest rate, which are currently around 1% to 2%.
Keep in mind that the carrier never invests the money directly in stocks. Instead, it invests in options to buy all the stocks in a particular market index. Many people get confused and think that index annuities involve investments in stocks, but they do not.