If I were to ask you what the perfect retirement investment is, I'm sure you would say something along the lines that it should provide a great interest return, be liquid, have minimum taxes due on the gain and protect you from losing principal. Up to about 10 years ago, no such thing existed because, as you know, there is no gain without risk. As a matter of fact, the greater the potential gain, the greater the risk. That's true of virtually all investments.

Introducing Indexed Annuities or "How To Have Your Cake and Eat It"

Indexed annuities were created about 10 years ago by some forward-looking, creative insurance companies in an attempt to provide the consumer with a product that is extremely suitable for retirement. Before I go into the details of the features of an indexed annuity, I would first like to describe the features of all annuities.

As you probably already know, an annuity is a contract with an insurance company that enables you to receive a steady, fixed payment for a specified number of years depending on the amount of money invested. In a way, annuities are similar to CD's except for the fact that your money is invested with an insurance company versus a bank and since insurance companies are highly regulated, your money is actually safer invested with a quality insurance company.

Essentially there are 4 types of annuities as follows:

1. Immediate annuities 2. Fixed Annuities (deferred) 3. Variable Annuities 4. Indexed Annuities

Here is a brief description of each of the above annuities.

Immediate annuities start paying you a monthly income the very next month after you invest your money. The period of time that you choose to receive payments can be as little as 5 years or a lifetime.

Fixed Annuities are also referred to as deferred annuities since the money accumulates in the account for a certain number of years after which you can choose to "annuitize" your account which means that you now start to receive a fixed monthly payment depending on the amount of money that has accumulated. The problem with these annuities in the past has been that the returns have not been that high but, nevertheless, higher than CD's. Of course, the great benefit of ALL annuities, is that money continues to grow inside the account on a tax-deferred basis which makes all annuities superior to CD's as a retirement investment.

Variable Annuities - unlike fixed annuities, variable annuities can pay very high returns since the performance is tied to underlying stock and mutual funds and therefore, if the market goes up, so will your account. The big problem here is that you can also lose a substantial amount of principal.

Indexed Annuities To The Rescue

In order to resolve the problems associated with the above traditional annuities, insurance companies created the "indexed annuity" which combines the best features of all annuities into 1 product. Through the use of very sophisticated investment techniques, insurance companies were actually able to create a product that enables you to get a nice return and participate in the stock market without risking principal! Exactly How An Indexed Annuity Works

When you invest in an indexed annuity, you have the option of allocating your money into a fixed account or the indexed account. The indexed account is tied to one of the major stock indexes such as the Dow Jones Industrial average, the S&P 500, etc. Now, one very important thing to note here, is that your money is NOT invested in the market but in the annuity contract. Therefore, you CANNOT lose principal. The insurance company protects itself by investing in stock call options and some sophisticated bond investing.

Let's look at a typical investment in an indexed annuity. The amount of money invested will be $100,000 and allocated between the fixed and indexed accounts as follows:

Example

$50,000 will be allocated to the fixed account paying 4% annually and $50,000 will be allocated to the indexed account (let's use the S&P 500).

The investment will take place on 1/1/2008. Let's say that the S&P 500 value on Jan 1, 2008 is 1500. This value will be used as the starting point to track the performance of the indexed account.

It's now Jan. 2009, 1 year has transpired and the S&P 500 is now at 1,700. Let's also assume that the insurance company puts a CAP on your return of 7%. This is how the insurance company protects itself! This is how your investment account will look on 1/1/2008.

The fixed account will be $52,000 representing the 4% gain as set forth at the beginning of the contract. The S&P index has skyrocketed to 1,700 representing a 13.3% gain. However, because a cap applies to indexed accounts, you will receive the cap rate of 7%.

So, your account will have a total of $52,000 (fixed) + $53,500 (indexed account) = $105,500.

What Happens When The Stock Market Goes Down

Now, what happens when the market goes down is actually the best part about indexed annuities because you're totally protected from loss. Let's say you continue to get that 4% in the fixed account and the S&P index on Jan.1, 2010 plummets to 1400 (a very real possibility). With most investments, you would lose substantial money (as happened with the crash in 2000) but with the indexed annuity, your principal remains intact and you get a 0% return which is a whole lot better than a 17% negative return. And that is what I love about indexed annuities. You can participate in the stock market up to a point but still protect your self from loss.

So, your account after 2 years in the above example has a balance of

$107,080 consisting of $54,080 in the fixed account and $53,500 in the indexed account. The most important principle to remember when you hit pre-retirement age is that NOT losing principal is far more important than the interest rate you receive.

The above example is meant to show you the basic idea of how an indexed annuity works. There are many variations on this theme depending on the company you invest with and the indexing method used. At least, you'll now have the basic idea - you can get nice returns each year WITHOUT subjecting your principal to risk.

A Word About Surrender Charges

Many people feel that their money should not be "tied up" in an annuity because surrender charges are imposed if the money is withdrawn prematurely. However, this too is a myth, and you can find out more aboutthe details by reading my free ebook as described below. Summary

If you're looking for a way to save for retirement, protect your principal from loss and still get a nice return, investing in an indexed annuity would be a good option. Obviously, you should discuss this with your advisor.

Joseph Barbarite The Retirement Pro www.MyRetirementSnapshot.com  To learn about other very important topics concerning your retirement, I've written an ebook entitled "Retirement Survival Guide". You can download it or free at www.FreeRetirementSurvivalGuide.com

Article Source: DesireToRetire.com We have the internet's best retirement calculators!  Click here to try them out