Equity-indexed annuities are a type of contract that gives you the potential to earn interest based on the performance of a particular stock market index. It’s essential to understand how these contracts work before you invest, so in this guide, we will break it down for you. First, we’ll discuss what an equity index annuity is, how it works, and some of the benefits and drawbacks of investing in them.
- What Is An Equity Index Annuity?
- How An Equity Indexed Annuity Works
- Earning Interest On Equity-Indexed Annuities
- How Are They Different From Other Fixed Annuities?
- How Equity-Indexed Annuities Credit Interest
- Equity-Indexed Annuities Disadvantage
- Equity Indexed Annuities Pros And Cons
- Which of The Following Is Not A Feature Of Equity-Indexed Annuities?
- Equity Index Annuity Calculator
- Next Steps
- Equity Indexed Annuity Quotes
What Is An Equity Index Annuity?
An equity-indexed annuity is a fixed annuity that earns interest based on the performance of an index, such as the S&P 500. This means that if the market goes up, so does the value of your annuity. However, if the market dips, your investment is still protected by the guaranteed rate of return. Therefore, an index equity annuity is also known as a fixed index annuity.
When you buy an equity-indexed annuity, you own an insurance contract. Therefore, 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.
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 complete 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%, on 87.5% of your investment. This minimum interest rate applies if an investor earns no returns throughout 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 and 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.
Investors receive protection against downside risk in exchange for limited profits, 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. For example, 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 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. Therefore, 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 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 specific participation rate for a set term. Then, the company established a new participation rate for the next term when that term ended. Some annuities guarantee that the participation rate will not be reduced below or increased beyond a maximum.
Cap Rate
Some annuities may impose a maximum index-linked interest rate. The highest rate of interest the annuity will pay is 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 earnings. 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 is known as a margin, spread, or fee.
Vesting
In the case of premium bonuses, if you withdraw your money before the end of the contract’s term, some annuities may not credit any of the bonus or just a portion. The percentage 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 cancels 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
| Pros | Cons |
|---|---|
| No Contribution Limits | Long-Term Contracts |
| Guarantee On Investment | Surrender Charges |
| Tax-Deferred or Tax-Free Growth | Additional Fees |
| Pass Down to Beneficiaries | Tax Penalties If Withdrawn Too Early |
| Spousal Continuance | Limited Upside Potential |
| Stock Market Volatility Protection | Caps and Rates Can Be Lowered |
| Guaranteed lifetime Income | Limited Liquidity |
| Helps To Pay For Long-Term Care | |
| Life Insurance Alternative |
Which of The Following Is Not A Feature Of Equity-Indexed Annuities?
- EIAs are not investments (securities) but rather insurance policies.
- Owners are guaranteed not to lose money to a market downturn.
- They are not short-term investments.
Equity Index Annuity Calculator
An equity index annuity is one of the best ways to efficient retirement income planning. Indexed annuities will provide guaranteed income for the rest of your life, so you don’t have to worry about running out of money in retirement. Project how much retirement income you can receive for life with our equity annuity calculator. Then contact us for a free quote below.
Next Steps
Now that you know more about equity index annuities, you may wonder if one is suitable for your investment portfolio. These contracts can offer some advantages, such as the potential to earn interest based on stock market performance and peace of mind knowing that your principal investment is protected. However, there are also some drawbacks to consider before investing, such as surrender charges and caps on earnings.
If you’re still unsure whether an equity index annuity is right for you, our team at The Annuity Expert can help. We’ll take the time to get to know your unique financial situation and goals and provide a tailored quote. In the meantime, check out our blog for more information on various financial topics.
