The Equity Indexed Annuity

Shawn Plummer

CEO, The Annuity Expert

What is an equity indexed annuity?

An equity-indexed annuity is a type of fixed annuity that earns interest based on a portion of an equities index, typically the S&P 500. An index equity annuity is also known as a fixed index annuity.

When you buy an equity-indexed annuity you own an insurance contract. You are not buying shares of any stock or index.

Equity-indexed annuities appeal to many people, especially those who want some opportunity to earn a higher return than what’s available with traditional fixed-rate annuities but still want protection should things go wrong.

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How an Equity Indexed Annuity Works

An annuity is an insurance policy for retirement with an insurance company. There is an accumulation period where the policy earns interest. At the end of the accumulation period, the investor has full control of the initial investment and earned interest. In addition, there is an optional payout period called annuitization.

Equity-indexed annuities provide a guaranteed minimum interest rate, typically 1% to 3% paid on 87.5% of your investment. This minimum interest rate applies if an investor earns no returns over the course of the contract. Thus, the primary method of earning interest is linked to the performance of an external equities index.

Earnings from index equity annuities are usually higher than traditional fixed-rate annuities, lower than variable-rate annuities, but with better downside protection than a variable annuity.

Earning Interest on Equity-Indexed Annuities

Indexed equity annuities offer a participation rate that can limit the extent to which the annuity owner can participate in market gains.

In exchange for limited profits, investors receive protection against downside risk, breaking even each year a down market occurs.

Some annuities have a cap on the total interest they can earn.

Annuities that use indexed funds (funds with changes based on market performance) have calculation formulas to measure performance. The annual reset formula looks at the index gains without considering any declines, which can benefit during “down years” in the stock market.

How Are They Different from Other Fixed Annuities?

The way an equity-indexed annuity credits interest to the value of your annuity is what sets it apart from other fixed annuities. Fixed annuities that only credit interest at a rate specified in the contract are available. Other fixed annuities also credit interest at intervals set by the insurance company.

An equity-indexed annuity accrues interest using a calculation that is based on index changes. How much additional interest you get and when you get it depends on the features of your particular annuity.

An equity-indexed annuity, like other fixed annuities, guarantees to pay a minimum interest rate. Even if the index-linked interest rate is lower, the rate that will be applied will not be lower than this guaranteed minimum. Your annuity’s value won’t fall below a set minimum regardless of what happens.

How Equity-Indexed Annuities Credit Interest

The equity in an equity-indexed annuity is linked to the returns of a stock index, such as the S&P 500. The following describes how equity-indexed annuity’s index-linked formula to credit interest.

Indexing Method

The indexing method refers to the technique used to quantify any change, if any, in the index.

Term

The index term is the time period over which interest on your annuity is calculated; it is paid out to you at the end of a term.

Participation Rate

The participation rate determines how much of the index’s growth is used to calculate the indexed interest. The insurance company usually promises a certain participation rate for a set term. When that term has ended, the company establishes a new participation rate for the next term. Some annuities guarantee that the participation rate will not be reduced below a given minimum or increased beyond a given maximum.

Cap Rate

Some annuities may impose a maximum index-linked interest rate. The highest rate of interest the annuity will pay is known as the cap rate. Cap rates are not found in all annuities.

The Floor: “Zero Is Your Hero”

The minimum index-linked interest rate you will get is the floor. The most frequent floor is 0%. A 0% floor ensures that your index-linked interest will be zero rather than negative even if the index decreases in value.

Averaging

In certain annuities, the average value of an index is used instead of the actual value of the index on a specific date.

Interest Compounding

Equity-index annuities offer either simple or compounding interest on earning. Simple interest means index-linked interest is added to your original premium amount but does not compound during the term. Compound interest means that index-linked interest that has already been credited also earns interest in the future.

Margin, Spreads, and Fees

The index-linked interest rate in some annuities is determined by subtracting a certain proportion from any change in the index. This percentage, known as a margin, spread, or fee.

Vesting

In the case of premium bonuses, if you withdraw all of your money before the end of the contract’s term, some annuities may not credit any of the bonus or just a portion of it. The percentage that has been earned, or credited, usually increases as the term approaches its conclusion.

Annual Reset

Index-linked interest earned is added and “locked-in” to your annuity each year during the term.

Any interest earned will not be decreased if the index falls. As a result, when the index swings up and down frequently throughout the term, your annuity utilizing the annual reset method may credit additional interest than other annuities.

Note: Your annuity’s participation rate may change each year.

Are Dividends Included in the Index?

Dividends paid on stocks in the index may or may not be included in the index’s value.

Equity-Indexed Annuities Disadvantage

The primary disadvantage of equity-indexed annuities is surrender charges. If the annuity owner decides to cancel the annuity, cancellation penalties can be high. In addition, accessing the funds before the age of 59½ will be subject to a 10% tax penalty.

Equity Indexed Annuities Pros and Cons

ProsCons
No Contribution LimitsLong-Term Contracts
Guarantee On InvestmentSurrender Charges
Tax-Deferred or Tax-Free GrowthAdditional Fees
Pass Down to BeneficiariesTax Penalties If Withdrawn Too Early
Spousal ContinuanceLimited Upside Potential
Stock Market Volatility ProtectionCaps and Rates Can Be Lowered
Guaranteed lifetime IncomeLimited Liquidity
Helps To Pay For Long-Term Care
Life Insurance Alternative

Equity Index Annuities

Research equity index annuities, then request a quote.

Which of The Following Is Not A Feature Of Equity-Indexed Annuities?

  • EIAs are not investments (securities) rather insurance policies.
  • Owners are guaranteed not to lose money to a market downturn.
  • They are not short-term investments.

Equity Indexed Annuity Quotes

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Shawn Plummer

CEO, The Annuity Expert

I’m a licensed financial professional focusing on annuities and insurance for more than a decade. My former role was training financial advisors, including for a Fortune Global 500 insurance company. I’ve been featured in Time Magazine, Yahoo! Finance, MSN, SmartAsset, Entrepreneur, Bloomberg, The Simple Dollar, U.S. News and World Report, and Women’s Health Magazine.

The Annuity Expert is an online insurance agency servicing consumers across the United States. My goal is to help you take the guesswork out of retirement planning or find the best insurance coverage at the cheapest rates for you. 

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