An equity-indexed annuity, or EIA for short, is an annuity that earns interest that is linked to a stock or other equity index. One of the most commonly used indices is the Standard & Poor's 500 Composite Stock Price Index (the S&P 500). EIAs offer consumers what could be described as the best of both worlds: a market-driven investment with potentially attractive returns, plus a guaranteed minimum return. In short: You get less upside but much less downside.
An equity-indexed annuity is in the category of "Fixed" annuities. That means, you may earn a comfortable return on your money while deferring the taxes on your gains. Fixed annuities also offer specified annual company-guaranteed returns. Variable annuities, on the other hand, let you decide where to allocate your funds in any number of mutual funds and, therefore, perhaps offer better returns, but at a higher risk. While variable annuity products must be registered with the SEC, must issue prospectuses and can only be sold by professionals with securities licenses, EIAs are not federally regulated and brokers don't need a securities license to sell them.
Understanding Equity-Indexed Annuities
Understanding the equity-indexed annuities market can be a somewhat daunting task. They're all different.
While it's a lot like investing directly in the stock market, you don't get the full boost of a rising market. With equity-indexed annuities, the money put down by you, as a purchaser, isn't invested directly in the stock market. Instead, you are offered a percentage of how much the index gains over a period of time, and a guaranteed minimum return if the stock market declines.
At predetermined times during the annuity's life, you are credited with a percentage of the gain of the index. The schedule varies with each annuity. Some offer annual "indexing," while others use various averages taken over the life of the annuity.
How Are Indexed Annuities Different From Other Fixed Annuities?
An equity-indexed annuity is different from other fixed annuities because of the way it credits interest to your annuity's value. Most fixed annuities credit interest calculated at a rate set in the contract. EIAs credit interest using a formula based on changes in the index to which the annuity is linked. The formula decides how the additional interest, if any, is calculated and credited. How much excess interest you get and when you get it depends on the features of your particular annuity.
Your equity-indexed annuity, like other fixed annuities, also promises to pay a minimum interest rate. The rate that will be applied will not be less than this minimum guaranteed rate even if the index-linked interest rate is lower. The value of your annuity also will not drop below a guaranteed minimum. For example, many single premium annuity contracts guarantee the minimum value will never be less than 90 percent (100 percent in some contracts) of the premium paid, plus at least 3% in annual interest (less any partial withdrawals). The insurance company will adjust the value of the annuity at the end of each term to reflect any index increases.
Note that most EIAs have surrender charges which are assessed in the early years of the contract if the owner surrenders it before the company has had the opportunity to recover its costs. The earnings portion of withdrawals are taxable as ordinary income and, if made prior to age 59½ are subject to a 10% federal penalty tax.
An equity-indexed annuity typically offers other benefits that are not generally included in traditional policies: a 100 percent money-back guarantee, no front-end sales charges, and no annual management fees or administrative fees. However, equity-indexed annuities can contain mortality and expense charges, cost-of-insurance charges, and administrative fees. Equity-indexed annuity values fluctuate with changes in market conditions.
The performance of any index is not indicative of the performance of any particular investment. Individuals cannot invest directly in any index. Past performance is no guarantee of future results.
Benefits of the Equity-Indexed Annuity
No-Loss Provision: The first and possibly most attractive provision of an equity-indexed annuity is the no-loss provision. This means that once a premium payment has been made or interest has been credited to the account, the account value will never decrease below that amount. This provides safety against the volatility of the S&P 500.
Interest Guarantees: The next benefit of an equity-indexed annuity with wide appeal is interest guarantees. Most policies have a cap (the maximum interest rate that can be credited to a policy in a policy year) and a floor (the minimum interest rate that can be credited in a policy year). The cap rate can vary from no cap to a fixed percentage, but the floor is generally zero. This allows the policyholder to benefit from potentially high returns and be guaranteed at the same time that no money will be lost.
Competitive Rates of Return: With concerns over inflation and making sure that investments will meet our future needs, many people have turned to the equity market for higher returns. It makes sense when you consider how well the S&P 500 index has performed historically.
Two contract features that have the greatest effect on the amount of additional interest that may be credited to an equity-indexed annuity are the indexing method and the participation rate. It is important to understand these features and how they work together. We devote a full section below to Indexing Methods, followed by a discussion of participation rates.
Indexing Methods of Equity-Indexed Annuities
There are six main indexing methods of equity-indexed annuities, each with its own variations and benefits:
The European, or Point-to-Point, Method divides the index on the maturity date by the index on the issue date and subtracts 1 from the result. (Other indexing methods use this same formula, with different data points.) This ignores all the fluctuations between start and finish, and makes this method the simplest both to understand and to calculate. One drawback is that market fluctuations can produce very different results for customers who bought the policy just a few days apart. The method's name comes from European stock markets, where options can only be exercised on their expiration date.
Again, the Point-to-Point method refers to the change, say, in the S&P 500 Index from the beginning of the term to the end of the term. The term period may be one policy year or 3, 5 7 policy years. The index-linked interest, if any, is based on the difference between the index value at the end of the term and the index value at the start of the term. Interest is added to your annuity at the end of the term.
Advantage: Since interest cannot be calculated before the end of the term, use of this design may permit a higher participation rate than annuities using other designs.
Disadvantage: Since interest is not credited until the end of the term, typically six or seven years, you may not be able to get the index-linked interest until the end of the term.
The Asian Method involves averaging several points of the index to establish the beginning and/or ending index. This method can help shield you from the risk of a market decline on the maturity date. Some companies take an average of the 12 monthly indices to establish the policy's maturity index level. This method takes its name from the Asian stock markets.
The Look-back or High-water Mark Method is another popular approach. On each policy anniversary, the company notes the index level. The highest of these is then taken and figured as the index level on the maturity date. In other words, the index-linked interest, if any, is decided by looking at the index value at various points during the term, usually the annual anniversaries of the date you bought the annuity. The interest is based on the difference between the highest index value and the index value at the start of the term. Interest is added to your annuity at the end of the term.
Advantages: Since interest is calculated using the highest value of the index on a contract anniversary during the term, this design may credit higher interest than some other designs
if the index reaches a high point early or in the middle of the term, then drops off at the end of the term.
Disadvantages: Interest is not credited until the end of the term. In some annuities, if you surrender your annuity before the end of the term, you may not get index-linked interest for that term. In other annuities, you may receive index-linked interest, based on the highest anniversary value to date and the annuity's vesting schedule. Also, contracts with this design may have a lower participation rate than annuities using other designs or may use a cap to limit the total amount of interest you might earn.
The Low-water Mark Method uses the lowest of the indices on each of the policy anniversaries before maturity as the level of the index at issue. This method tends to lessen the risk of market decline. Here the index-linked interest, if any, is decided by looking at the index value at various points during the term, usually the annual anniversaries of the date you bought the annuity. The interest is based on the difference between the index value at the end of the term and the lowest index value. Interest is added to your annuity at the end of the term.
The Annual Reset or Ratchet Method is among the most complicated. The increase in the index is calculated each policy year by comparing the indices on the beginning and ending anniversaries. Any resulting decreases are ignored. Appreciation is figured by adding or compounding the increases for each policy year. In other words, index-linked interest, if any, is determined each year by comparing the index value at the end of the contract year with the index value at the start of the contract year. Interest is added to your annuity each year during the term. This method locks in the gain for that period which is usually one policy year. Once the interest is credited to your policy it becomes the value on which the next years gain is calculated.
Advantages: Since the interest earned is "locked in" annually and the index value is "reset" at the end of each year, future decreases in the index will not affect the interest you have already earned. Therefore, your annuity using the annual reset method may credit more interest than annuities using other methods when the index fluctuates up and down often during the term. This design is more likely than others to give you access to index-linked interest before the term ends.
Disadvantages: Your annuity's participation rate may change each year and generally will be lower than that of other indexing methods. Also, an annual reset design may use a cap or averaging to limit the total amount of interest you might earn each year.
The Spread Method calculates the increase in the S&P 500 for that policy year or term then subtract a percentage from that change. For example if the the gain in the S&P 500 for a policy year was 12% and the company used a spread of 2%, then, 10% would be credited to your policy for that year.
The participation rate decides how much of the increase in the index will be used to calculate index-linked interest. For example, if the calculated change in the index is 9% and the participation rate is 70%, the index-linked interest rate for your annuity will be 6.3% (9% x 70% = 6.3%). A company may set a different participation rate for newly issued annuities as often as each day. Therefore, the initial participation rate in your annuity will depend on when it is issued by the company. The company usually guarantees the participation rate for a specific period (from one year to the entire term). When that period is over, the company sets a new participation rate for the next period. Some annuities guarantee that the participation rate will never be set lower than a specified minimum or higher than a specified maximum.
The participation rate may vary greatly from one annuity to another and from time to time within a particular annuity. Therefore, it is important for you to know how your annuity's participation rate works with the indexing method. A high participation rate may be offset by other features, such as averaging, or a point-to-point indexing method. On the other hand, an insurance company may offset a lower participation rate by also offering a feature such as an annual reset indexing method.
Most equity-indexed annuities offer participation rates between 70 and 90 percent, and some place a cap on how much you can gain. If the product has a 14 percent cap, and the market gains 34 percent, you're stuck with 14 percent.
Say you plunk down $5,000 (a typical sum) for an equity-indexed annuity with an 80 percent participation rate and a 14 percent cap. If the S&P 500 goes up 15 percent, you'll gain $600. If you'd invested your $5,000 directly in the stock market, you'd have gained $750.
Cap Rate or Cap
Some annuities may put an upper limit, or cap, on the index-linked interest rate. This is the maximum rate of interest the annuity will earn. In the example given above, if the contract has a 6% cap rate, 6%, and not 6.3%, would be credited. Not all annuities have a cap rate. While a cap limits the amount of interest you might earn each year, annuities with this feature may have other product features you want, such as annual interest crediting or the ability to take partial withdrawals. Also, annuities that have a cap may have a higher participation rate.
Floor on Equity Index-Linked Interest
The floor is the minimum index-linked interest rate you will earn. The most common floor is 0%. A 0% floor assures that even if the index decreases in value, the index-linked interest that you earn will be zero and not negative.
In some annuities, the average of an index's value is used rather than the actual value of the index on a specified date. The index averaging may occur at the beginning, the end, or throughout the entire term of the annuity. Averaging at the beginning of a term protects you from buying your annuity at a high point, which would reduce the amount of interest you might earn. Averaging at the end of the term protects you against severe declines in the index and losing index-linked interest as a result. On the other hand, averaging may reduce the amount of index-linked interest you earn when the index rises either near the start or at the end of the term.
In some annuities, the index-linked interest rate is computed by subtracting a specific percentage from any calculated change in the index. This percentage, sometimes referred to as the "margin," "spread," or "administrative fee," might be instead of, or in addition to, a participation rate. For example, if the calculated change in the index is 10%, your annuity might specify that 2.25% will be subtracted from the rate to determine the interest rate credited. In this example, the rate would be 7.75% (10% - 2.25% = 7.75%). In this example, the company subtracts the percentage only if the change in the index produces a positive interest rate.
Are Equity-Indexed Annuities a Good Investment?
If you had bought an equity-indexed annuity just before the collapse of the stock market instead of investing in the stock market itself, you would be very happy right now!
Before you invest in an equity-indexed annuity you will want to read the fine print. There are surrender charges for early withdrawal, although most companies now allow yearly withdrawals at set amounts. Notably, the surrender charges often decrease the longer you let the company keep your money.
This type of investment is advantageous for someone who is young and willing to allow the earnings to mount for retirement. If you don't need the money and are not dependent on it, an indexed annuity is your best bet. Depending on your situation, all of your earning potential may be ahead of you, so leaving it alone is the way to go.