What is an equity-indexed annuity? A better first question is “What is an annuity?” An annuity is essentially a contract between a seller and a buyer. The seller is referred to as the “issuer,” and the buyer is called the “annuitant.” The issuer is usually a financial institution, commonly an insurance company.

The agreement is that the issuer will provide either a series of payments or a single lump sum in exchange for money right now. The disbursements can start immediately or at a set time in the future. They may last for a specific period of time or until death.

There are 3 types of annuities:

  1. Fixed. In this type of annuity, the payments are guaranteed and fixed throughout the duration of the annuity contract.
  2. Variable. Variable annuities provide several investment options. The annuity payment is then based upon the performance of those investments. You could get more, or less, from a variable annuity than from a fixed annuity.
  3. Equity-indexed. The payout amounts vary, which makes an indexed annuity similar to a variable annuity. However, the equity-indexed version is tied to a specific equity index.

‣  The most common indices used are the International Index, the Dow Jones Industrial average, and the S&P 500. The payouts are based on the performance of that targeted index.

‣  There is a guaranteed minimum interest rate on your earnings. This rate is most often between 1% and 3%, based on a minimum of 87.5% of the premiums paid.

‣  It’s unlikely that you’ll lose money with an indexed annuity, but you won’t do well if the market does poorly.

‣  However, if you decide to surrender your annuity early, the penalties can be enough to create a loss.

The downside is that you’ll likely never earn the same returns you could get in the stock market.

The attractive component of an indexed annuity is the ability to enjoy better gains than you could typically get from bonds, certificates of deposit, and money market accounts, with less risk of losing money in the stock market. Also, your earnings are tax deferred.

 How is the actual interest rate calculated?

No one will ever say that equity-indexed funds are simple. The real complication of this investment lies in the calculation of the interest paid.

There are a few terms to understand:

  1. Interest Rate Cap. This is the maximum amount that the annuity will pay. A common cap rate is 8%. The equity index could go up 20%, but you’re still only going to receive 8% (in our example). Not all indexed annuities have caps.
  2. Participation Rate. Some, but not all, equity-indexed annuities use this method for interest rate calculation. It is expressed as a percentage, typically between 80-90%. You would be credited with that percentage of the increase in the tracked index.

‣  So, if the participation rate was 90%, and the market index increased 10%, you would get 90% of that increase, or 9%.

  1. Spread/Margin/Asset Fee. These are all terms for the same thing. This is the amount that is subtracted from the tracked index. If this fee was 3%, and the market increased 8%, your return would be 5%.

‣  Some annuities use both a participation rate and this additional spread/margin/asset fee. This would result in lower terms.

It’s very important to investigate how the issuer is doing the calculations to determine your rate of return. It’s easy to play games with all the numbers.

But what base value is used in the calculations?

There are 3 primary ways to determine the base value:

  1. High Water Mark. This method compares the value of the tracked index from the start date of the annuity to the end of each year.
  2. Annual Reset. The change in value of the index from the beginning of the each year to the end of the year is used. Only increases in the market are used, never declines. An annuity using this method will often have lower cap and participation rates.
  3. Point-to-Point. Specific dates are used to determine the market return, most often the beginning and ending date of the annuity. The terms tend to be more attractive, but there is a potential downside: The market might do great for years and then drop like a stone near the end of the annuity term.

Each method has its advantages and disadvantages. Be sure you research the differences before making a final decision.

Is an equity-indexed annuity the right option for your situation?

Indexed annuities can be excellent investment products for the right investor and situation.

The risk of an indexed annuity is higher than that of a fixed annuity, but the returns also tend to be higher.

The situation is reversed when comparing indexed annuities to variable annuities. Variable annuities have a greater degree of variability, more risk, and typically better returns.

Annuities are long-term, tax-deferred investments. Getting your money back out before reaching age 59.5 will mean a penalty and tax charges. Remember that waiting until retirement will usually result in lower taxes, since your income will likely be less and you’ll be in a lower tax bracket. If you’re likely to need the money sooner, there are better investment options available.

The key is determining your tolerance for risk, your timeline, and your expertise.

Finding the right annuity for your unique situation can be a challenge, so it’s important to do your research. These are complex financial products. If you have questions, an excellent resource is your state insurance commissioner.


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