What is an equity-indexed annuity?
An equity-indexed annuity is a hybrid between a fixed and variable annuity. It is a fixed annuity by legal statute, but it has offerings inside of it that allow the contract holder to invest in stock market indices such as the S&P 500, Dow Jones, and Nasdaq 100. One of the main features of EIA's are their ability to guarantee a floor to your earnings with no loss once earned. If your account credits from $50,000 to $53,000 in a given contract year, most EIA contracts will guarantee that you will not "back up" from $53,000 but rather earn $0 if the market loses the following year. EIA's offer fixed accounts within their contracts that offer a guaranteed rate for usually one year. Like almost all annuities, EIA's have surrender charge periods (usually 5-10 years) that encourage the contract holder to only withdraw a small portion if needed to help foster long-term growth. EIA's can be an excellent addition to a portfolio that is trying to mitigate risk but also add a growth component to a conservative approach. EIA's are commonly misunderstood in the general public, but a good investment advisor can provide the full features of the investment vehicle that could make a position in a well-balanced portfolio.
Jason R. Tate, ChFC, CLU, CASL
Jason Tate Financial Consulting
Company Website: jtfc.net
An equity indexed annuity is a brilliant invention by insurance companies to make a ton of money under the guise of safety and security. Seriously....look at the hundreds of millions, even billions of dollars that are going into these fantastic financial products every year. Insurance companies are making money hand over fist because most of the time, they control the purse strings. They can tweak the annuity contract fees and expenses to guarantee that they make a profit first, and annuity buyers continue to line up for the deal.
An equity indexed annuity is an insurance product offered by insurance companies that, for exchange of your money, will link the performance of your annuity to some type of underlying market index like the S&P 500, Dow Jones, Gold, etc. I have even seen equity indexed annuities that are linked to the inverse S&P 500. When the market goes down, you make money--fantastic!
SHOULD YOU BUY AN EQUITY INDEXED ANNUITY?
Maybe, maybe not. This is a serious decision, that has long term consequences. Before you buy any annuity, you should look at your annuity alternatives. Why would you buy an annuity in the first place? What problem are you trying to solve? What do you want your money to do?
Once you've decided that you need an annuity to solve your problem, and this has been mathematically validated, then you need to decide which annuity you need to buy. This is where a professional can come into play. Equity indexed annuities are a BIG business and there are hundreds of companies offering thousands of different types of equity indexed annuities. Fortunately, there are independent advisors that can get side by side price comparisons of all of these annuities so you can see the pros, cons, features, fees, expenses, and performance measures before you buy.
ARE EQUITY INDEXED ANNUITIES A GOOD DEAL?
Yes--for the insurance company, and you want this to be the case. Theres no use in buying an annuity from a cheap insurance company that could go out of business. Are they a good deal for you? Depends on which one you buy....again they can be a great deal for you, you just need to get an independent analysis before you buy. Do it!
An equity-indexed annuity is an alternative investment to a traditional fixed rate or variable rate annuity, and it may be appealing to moderately conservative investors. Equity-indexed annuities are distinguished by the interest yield return being partially based on an equities index, such as the S&P 500 index.
An annuity is essentially an investment contract with an insurance company, traditionally used for retirement purposes. The investor receives periodic payments from the insurance company as returns on the investment of premiums paid. There is an accumulation period when the premiums paid earn interest in accordance with the terms of the annuity contract, followed by a payout period. Part of the interest rate earned is a guaranteed minimum, commonly 1-3% paid on 90% of premiums paid; the other part is linked to the specified equities index. Earnings from equity-indexed annuities are usually slightly higher than traditional fixed rate annuities, lower than variable rate annuities but with better downside risk protection than variable annuities usually offer.
A key feature of equity-indexed annuities is the participation rate, which is basically a limit that proscribes the extent to which the annuity owner participates in market gains. If the annuity has an 80% participation rate, and the index to which it is linked shows a 15% profit, the annuity owner participates in 80% of that profit, realizing a 12% profit. In return for accepting limited profits, he or she receives protection against downside risk, usually a guarantee of at least breaking even each year that interest is earned in terms of the equity index portion of earned interest. Some equity annuities also have an absolute cap on total interest that can be earned. Another aspect to consider is whether or not interest earned is compounded.
Equity annuities use one of three calculation formulas to determine the changes in the equity index level that interest payments are calculated from. The most common is the annual reset formula, which simply looks at index gains and ignores declines. This approach can be a substantial benefit during down years in the stock market. A second formula, the point-to-point method, averages the index-linked return from the index gains at two separate points in time during the year. The third option, the high-water mark, looks at the index values at each anniversary date of the annuity and selects the highest index value from those to then be averaged with whatever the index value was at the beginning of the payment term.
One disadvantage of equity-indexed annuities is high surrender charges. If the annuity owner decides to cancel the annuity and access the funds early, cancellation fees can run as high as 15% in addition to a 10% tax penalty. Historically, equity-indexed annuities have also been subject to high commission fees, up to 5%.
Equity-indexed annuities are relatively complex investments and not appropriate for novice or unsophisticated investors. There are numerous factors that can significantly affect the investment's potential profitability. Some analysts question whether these annuities can be considered a good investment at all. The general appeal of equity-indexed annuities is to moderately conservative investors who like having some opportunity to earn a higher investment return than what's available from traditional fixed-rate annuities while still having some protection against downside risk.
An equity-indexed annuity is an insurance product that tracks a major market index. They may sound great, especially if you hear "guaranteed return", "the value cannot go down", or other incredible claims. However, note that they usually have high upfront sales charges, capped returns, surrender penalties, and other feature fees. Also, if you initiate the payout phase, you lose control of your principal, which is liquidated during your lifetime. A balanced ETF portfolio can be a much better option based on your goals.
Be careful about taking advice about any complicated investment vehicle where the advice is strongly biased (positive or negative). One of the answers on this question seems to be extremely biased saying that this is an instrument made by insurance companies for their own profit (which is true). However, most companies that offers an investment vehicle are doing so for profit (since they are not charitable organizations). Mutual funds, hedge funds, banks, and insurance carriers all offer products to make a profit. But they must offer a product valuable to investors to stay competitive and attract funds.
Investopedia's answer is the most appropriate stating that these are investment contracts that offer attractive risk adjusted returns for moderately conservative investors. The average returns on equity indexed annuities (or fixed indexed annuities) tend to be higher than fixed annuities or bank products due to the linking to index returns. But they offer principal protection from market downturns.
Conversely, the average returns tend to be lower than at risk investments such as stocks or real estate due to limitations set by the insurance company (usually represented by a contract fee or a cap, spread, or participation rate on the index allocation selected).
There are a number of factors one should evaluate before investing in an equity indexed annuity (including but not limited to: rates, indexes, crediting strategies, surrender charges, surrender fees, riders, etc.).
The information, data, analyses and opinions contained herein do not constitute legal advice offered by Kinetic and are provided solely for informational and educational purposes. While the information and statistical data contained herein are based on sources believed to be reliable, Kinetic does not represent that it is accurate and should not be relied on as such or be the basis for a decision. Kinetic Financial & Insurance Solutions, Inc. and Kinetic Investment Management, Inc. are two separate entities. Insurance products and services are offered and sold through individually licensed and appointed agents in all appropriate jurisdictions under Kinetic Financial & Insurance Solutions, Inc. Investment Advisory Services are offered through Kinetic Investment Management, Inc. a registered investment adviser.