Indexed Annuity Learning Guide

An equity-indexed (also known as a fixed-indexed) annuity is an annuity that earns interest that is linked to a stock or other equity index. They are also referred to as EIA’s or FIA’s, for short. One of the most commonly used indices is the Standard & Poor's 500 Composite Stock Index (the S&P 500), but many annuities will utilize other indices, such as the DJIA or Russell 2000.


An equity-indexed annuity is different from a more traditional fixed annuity because of the way in which it credits interest to the annuity's value. Most fixed annuities only credit interest calculated at a rate set in the contract – usually a fixed rate. Equity-indexed annuities credit interest using a formula based on changes in the index to which the annuity is linked. The formula will dictate whether there is interest that will be credited to the annuity’s contract value. How much interest that is credited depends upon the terms of the contract and the performance of the particular crediting method during a specific time period.

In an indexed annuity, the insurance company credits the policy with a return that is based on changes in an index. Indexed annuity contracts also provide that the contract value will be no less than a specified minimum rate of interest, regardless of index performance. Generally speaking, indexed annuities have principal protection provided that you play by the rules of the contract (see information on surrender charges).

Equity-indexed annuity contracts vary, and consist of several different components. It is prudent for potential investors to understand certain contract features that may affect the index-linked formula used to calculate interest.

It is important to understand that most indexed annuities have multiple crediting options. In addition, there may be a number of factors within each crediting method that determine the end interest result. Understanding the inner-workings of the various sub-components to index crediting is crucial for a consumer to understand when evaluating different index annuities.

Let’s discuss some of the components:

This is where an average of an index's value is used instead of an index's actual, date-specific value. This index averaging may occur throughout the annuity's entire term, or at the term's beginning, middle or end. Let’s look at an example of one of the commonly used averaging formulas known as monthly averaging:

Let’s assume that you purchase an annuity on January 1, and the crediting method you elect is the S&P 500 Monthly Average. This crediting method will often times have a “cap” on it where you are capped on how much you can earn.

Depending on how the market performs, monthly averaging may be advantageous OR disadvantageous. In the case of a steadily rising stock market index, monthly averaging might “dilute” the return. It’s important to carefully evaluate the math behind any crediting strategy so you understand exactly how interest is credited.

Participation Rates
An annuity's participation rate determines the extent to which an index's increase will be used toward computing the index-linked interest rate. This is another factor in determining how much interest is credited to the annuity. For example, if the participation rate for a particular crediting method is 70 percent and there is a 10 percent gain in the stock index over the year, then the equity index annuity would accumulate interest at 7 percent for that year (70% of the full 10% gain).

Indexing Method
This is the approach used to measure the amount of change in an index. Common indexing methods include ratcheting (reset) and point-to-point:

Ratcheting, or annual reset, determines an index's amount of change by comparing the value of the at the start of the contract year to the end of the contract year. Each year during the term, interest is added to the annuity (provided it is an annual reset product). Longer terms may apply (2 or 3 year annual reset period).

The point-to-point method is one of the easiest to understand. This method computes the index change by determining the difference between the start of the term's index value and the end of the term's index value. Interest is then added at the term's end. For example, if the stock market index starts at 1,000 and ends at 1,100, there is a 10% difference between the two.

Interest Rate Caps
Many equity-indexed annuities set a maximum interest rate that an annuity may earn. It should be kept in mind, though, that not all annuities have interest caps. For example, there may be a 6 or 8% annual cap on your earnings, which simply means that the most the particular annuity can earn annually is 6% or 8%, no matter how well the underlying index performs.

Interest Rate Floors
Many equity-indexed annuity contracts guarantee a minimum interest rate that an annuity will earn, with the most common floor being 0%. This type of floor percentage will ensure that an annuity's value will never be negative. Be sure to ask about “worst case” scenarios when evaluating indexed annuities.

Margin/Spread/Asset Fee
With certain equity-indexed annuities, their interest rates are determined by subtracting a certain percentage from any calculated index change. This percentage may be used as a substitute for, or in addition to, the participation rate. For example, if the index growth is 9%, the annuity contract might specify a 2% spread or margin (sometimes referred to as an asset fee) which will be subtracted from the 9 percent gain, resulting in a return of 7 percent.

KEEP IN MIND:Please keep in mind that the discussion above is only intended to provide an introduction to some of the components of indexed annuities. It is not considered to be all-inclusive. Insurance carriers are routinely adding new features and benefits to annuity contracts that may not be included in the above descriptions. It is important for all consumers to do their homework and ask questions of the insurance agent with whom they have selected to work. An indexed annuity may combine multiple means of interest calculation formulas, so please evaluate them carefully so you have a complete understanding of the product you are considering.

Equity Indexed Annuities have advantages and disadvantages, just like any financial instrument might. Let’s explore those:

Some Advantages of Equity-Indexed Annuities

·   Many Equity-indexed annuities offer “lock-in” features, which simply means that once a gain has been achieved and credited to the account, the account value can not go backwards from there (unless you take out withdrawals, fees, etc.).

·   Most annuity contracts have guaranteed minimum interest rates, meaning that you have principal protection inside of your account.

·   Traditional annuity benefits still apply to equity-indexed annuities. These benefits include tax-deferral and, in some cases, penalty free withdrawals.

·   Guaranteed death benefits for beneficiaries.

·   Several income payment options for owners. Most of these have guarantees provided by the insurance company as to how much income and for how long.

·   Indexed annuities give the owners the opportunity to participate in some of the upside of the stock market while protecting their downside risk. This may help fight inflation better than other “safe” investment alternatives.

Some Disadvantages of Equity-Indexed Annuities

Although there are a number of advantages to equity-indexed annuities, potential investors should also be aware that:

·   Some equity index crediting methods have a maximum cap, which could limit investors' earning potentials.

·   Some equity index contracts will penalize contract holders for any money withdrawals that exceed the annual allotted limit, so carefully evaluate what the “free withdrawal provisions” are before making a purchase.

·   Like all annuities, any withdrawals made before age 59.5 may be subject to a 10% penalty by the IRS.

·   Equity Indexed contracts are NOT designed to participate in ALL of the gain of the stock market, so your gains will be limited by the formulaic criteria set by the insurance company.

·   Some equity index contracts may have high surrender charges if you want access to your money and long surrender periods (meaning you’ll have to commit more time to the contract).