What is an equity-indexed annuity?
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.
Key Features of Equity-Indexed Annuities
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 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 a Fixed Annuity where the rate of interest is typically set to an index like the S&P 500 Index (but there are many more in today’s market). The crediting/rate of growth of the contract is typically set annually by the insurnce company issuing the contract and the contract is guaranteed by the underlying insurance company.
Here are some typical Pros and Cons:
- Equity-indexed annuities give holders equity participation as well as some safeguards if the stock market performs poorly.
- They typically give you some index upside and some downside protection (guaranteed by the insurance company).
- Offers tax-deferred growth and in some states a level of asset protection.
- In a strong up market, investors in these vehicles will see their gains muted.
- These vehicles are also complicated and can carry significant surrender charges, as well as a tax penalty if you need to sell before age 59 1/2
- Withdrawals are taxed as ordinary income.
These vehicles, often pitched as a happy medium between fixed and variable annuities, have exploded in popularity during the past several years. Although there are many different variations, the basic idea is the same: Equity-indexed annuities typically promise some guaranteed rate of return, much like a fixed annuity, but they also offer participation in equity market returns.
Under a typical scenario, an equity-indexed annuity will offer a minimum return that amounts to 90% of the premium paid at a 3% interest rate. In an up market, it will also offer a percentage of the return of a stock market index, usually the S&P 500. Some equity-indexed annuities cap the equity gains you're eligible to receive.
As with the other annuities, earnings in equity-indexed annuities increase on a tax-deferred basis, and holders pay income tax on their distributions. Equity-indexed annuities also typically include a death benefit. Additionally, when stocks were going up, critics bemoaned that owners of equity-indexed annuities would receive only a fraction of the stock market's gains. But as the stock market tanked from 2007 through early 2009, owners of these annuities were able to limit their stock market-related losses.
Still, there are a couple of persistent issues with equity-indexed annuities. The first is that they're complicated. Insurers use different methods of calculating the index return that holders pocket, and you need to read the fine print to determine how your own return will be calculated. Moreover, equity-indexed annuities don't typically include reinvested dividends when calculating index returns, yet dividends have historically accounted for nearly 40% of the market's total return. Finally, equity-indexed annuities often carry steep surrender charges, though some insurers waive them for medical reasons or other emergency expenses.
At the end of they day, even though they have the word “equity” in them and they are based on equity indexes in many cases, they typically have around a 4% to 6% type of return (that may vary greatly based on the contract) that you can expect to return. I typically think of them as “bond replacement” assets. At the end of the day, the insurance can company and contract’s and underlying guarantees are what is important, so make sure you know what you are buying. It is neither bad nor good, but it may make a good diversifier in your overall portfolio.
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.
An equity-indexed annuity is a fixed annuity where the interest crediting is based upon an equity index like the S&P 500. The sales pitch is you get "much of the upside with none of the downside." So in down years you remain flat, but in up years you a portion of the S&P return. They either have caps, say 8%, or monthly averaging (which essentially cuts the return in half).
So in a year when the S&P is up 15%, you get 8%. When negative, you get nothing. During a 4% year, you get 4%. So when you average all of those together, you will receive somewhere in the neighborhood of 3% to 4%. And if we enter into an extended bear market, the worst case scenario is a low simple interest, like 2%. Not 2% compounded, but 2% of on your principal. Pay no attention to the illlustration as that will not happen.
The bottom line is when you carefully analyze the math, whether caps, monthly averaging , etc.. the are created/structured to pay around 3% to 4% over time. And because it is a "fixed" contract with the return on crediting based upon an index, insurance agents call sell them without a securities license. The problem I have is that they have big commissions with long back-end surrender penalties, and therefore you are locking up your money. Another problem is if we hit an inflationary period, you cannot adjust (normally unless the particular contract had commodity indices choices).
While I have my insurance license, I do not sell them because I do not think they are worth the risks & illiquidity. There are better ways to make a safe, reasonable return than locking up your money over a long time period. I, personally, am in favor of strategies not products. Now, there are new indexed annuities coming out without commissions or surrender penalties and have a management fee instead. I will be analyzing those closely. If you are looking at indexed annuities, I would look at those carefully.
Hope this helps and best of luck, Dan Stewart CFA®