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Your Guide To Equity-Indexed Annuities

Equity-indexed annuities, in short, are a type of fixed annuity that is linked to a stock or other equity index, and accrues interest accordingly. The most commonly used index is the Standard & Poor's 500 Composite Priced Index (S&P500). Because of the way it credits interest to an annuity’s value, equity-indexed annuities differ considerably from other fixed annuities. Unlike most fixed annuities, equity-indexed annuities use a formula based on annuity-linked index changes to credit interest. How much interest is received, is based on each particular annuity’s features.

Like other fixed annuities, however, equity index annuities promise to pay a certain guaranteed minimum interest rate, meaning that an annuity’s value will not drop lower than the guaranteed specified minimum. Adjustments are also made to reflect index increases at the end of each term.

Equity-indexed Annuity Contract Features

Equity-indexed annuity contracts vary, and consist of several different components. It is advantageous for potential investors to understand certain contract features that may affect the index-linked formula used to calculate interest.

• Averaging

  This is where an average of an index’s value is used instead of an index’s actual, date-specific value. This index averaging may occur throughout the annuity’s entire term, or at the term’s beginning, middle or end.

• Participation Rates

  An annuity's participation rate determines the extent to which an index's increase will be used toward computing the index-linked interest rate. For example, if the participation rate is 70 percent and there is a 10 percent gain in the stock index over the year, then the equity index annuity would accumulate interest at 7 percent for that year.

• Indexing Method

  This is the approach used to measure the amount of change in an index. Common indexing methods include ratcheting, point-to-point and high water mark:

  • Ratcheting, or annual reset, determines an index’s amount of change by comparing the index’s value at the start of the contract year to the end of the contract year. Each year during the term, interest is added to the annuity.
  • The point-to-point method computes index change by determining the difference between the start of the term’s index value and the end of the term’s index value. Interest is then added at the term’s end.
  • The high-water mark method decides an index’s value by assessing the index value at different points during the term. The interest is then based on the difference between the highest index value and the index value at the beginning of the term, with interest being added at the end of the term.


• Interest Rate Caps

  Certain equity-indexed annuities set a maximum interest rate that an annuity may earn. It should be kept in mind, though, that not all annuities have interest caps.

• Interest Rate Floors

  Many equity-indexed annuity contracts guarantee a minimum interest rate that an annuity will earn, with the most common floor being 0%. This type of floor percentage will ensure that an annuity’s value will never be negative.

• Margin/Spread/Asset Fee

  With certain equity-indexed annuities, their interest rates are determined by subtracting a certain percentage from any calculated index change. This percentage may be used as a substitute for, or in addition to, the participation rate. For example, if the index growth is 10%, the annuity contract might specify that 2.50% will be subtracted from the 10 percent gain resulting in a return of 7.50 percent.

Advantages of Equity-indexed Annuities

Equity-indexed annuities offer distinct advantages over other types of investments being that they combine traditional annuity benefits with the potential to earn higher returns. Some of their highlights include:

• Equity-indexed annuities offer investors no-loss provisions, which means that once a payment or interest has been credit to the account, the account value will not go below that balance.
• Most annuity contracts have guaranteed minimum interest rates, meaning that investors are protected against money loss.
• Traditional annuity benefits still apply to equity-indexed annuities, including tax-deferred growth and, in some instances, penalty-free early withdrawals.
• Guaranteed death benefits for beneficiaries.
• Several income payment options so investors can receive income when and how they want it.
• Best of all, investors are able to participate in stock market growth, without being affected by stock market declines.

Equity-Indexed Annuity Disadvantages

Although there are a number of advantages to equity-indexed annuities, potential investors should also be wary of the fact that:

• Some equity index interest rates have a maximum cap, which could limit investors’ earning potentials.
• Some equity index contracts penalize annuitants for any money withdrawals that exceed the annual allotted limit.
• Withdrawals made before age 59.5 may be subject to a 10% penalty by the IRS.
• Investors may not receive the entire return of their linked market index with some equity index contracts.
• Several income payment options so investors can receive income when and how they want it.
• Some equity index contracts can have high surrender charges and long surrender periods.

Who Should Invest in Equity-indexed Annuities

Equity-indexed annuities are most ideal for long term investors who want to gain some of the benefits of a positive market, while protecting themselves from a down market. It’s important to note that the gains on equity indexed annuities may not be the same gains as seen against the index. Insurance companies can set limits on how much an investor can receive. For many, giving up some potential upside is a small price to pay for additional security – and a guaranteed return.

All Things Considered

For those who are suitable investment candidates for equity-indexed annuities, this type of annuity affords guaranteed minimum rates with the potential for higher returns. However, because equity-indexed annuity contracts can be complex, it is vital for all potential investors to understand the terms of the equity-indexed annuity being offered. Before deciding on an insurance company and a contract, investors should ask thorough questions, including:

1. What is the guaranteed floor interest rate?
2. What is the participation rate?
3. Which indexing method will be used?
4. How much are the surrender charges?
5. Are there any death benefits?
6. Is there a maximum interest rate that may be earned?
7. How is interest compounded?
8. What are some of the charges or fees? How are they deducted?
9. What are the penalties for early contract termination?
10. How much are withdrawal charges? In what circumstances are they waived?

As with any investment, investors must evaluate their own personal situation. It is important to understand the terms and trade-offs associated with equity indexed annuities prior to making any investment decisions.

Disclaimer
Many Equity Index Annuities ("Equity indexed annuities") are designed for long-term investing and have long vesting periods. Growth may not be realized prior to fulfillment of the vesting period. Potential returns are based on market fluctuations and calculation methods used for each individual index annuity. Earnings are taxable as ordinary income when withdrawn. Equity indexed annuities may have fees and expenses including surrender charges that will decrease performance. Annuities are not a deposit in any bank. They are not FDIC insured by any Federal Government Agency. Guarantees are based on the claims paying ability of the issuing company. Investors cannot invest directly in these indexes. Equity Indexed Annuities have limited liquidity and are not suitable for all investors. The guarantees of an annuity contract, including fixed returns, payouts, and death benefit guarantees are contingent on the claims-paying ability of the issuing insurance company. The principal amount of payments of an annuity purchased with funds from a qualified retirement plan may be taxable. With either systematic withdrawals or free withdrawals you will still be subject to regular income taxes, as well as the 10% tax penalty on early withdrawals prior to age 59 1/2. You may also incur surrender charges on amounts withdrawn in the early years of the contract.