Ratchet (a.k.a Equity-Indexed) Annuities Explained
A ratchet annuity or equity-indexed annuities are annuities that earn interest linked to stocks or other equity indices. A very common index that is used is the Standard & Poor (S & P) 500 Composite Stock Price Index (S & P 500). It is a term given to fixed index annuity because every year the value of the account is reset to include the year’s gain. The principal amount moves upward as a new basis in the contract. The account values are never adjusted downward.
What Makes the Ratchet Annuity Different From Other Kinds of Annuities?
The ratchet, or equity-indexed annuity is different because of how it applies interest to an existing annuity’s value. Other annuities only apply interest at a certain rate indicated in the contract. The Ratchet Annuity or (EIA) credit the interest applying a formula using changes in the index linked to the annuity. The formula dictates the amount of interest. The EIA or ratchet also ensures to pay a minimum interest rate. There exists a minimum guaranteed rate such that the value of the EIA does not drop below the indicated minimum.
Gains and Stability Amidst Market Declines
This kind of annuity allows for upside potential with downside principal protection. This entails that such fixed equities are less volatile than investments in the market, because they are not vulnerable to market declines and movements. Moreover, investments in stocks and mutual funds endure the declines or downward trends of the market.
What are the Disadvantages?
As far as market risk is concerned, there is no apparent downside. For instance, there are no investment handling fees like those charged for variable annuities. However, one disadvantage, which applies to all annuities, in that these types of investments are considered long term investments.
Another disadvantage is that fixed annuities do not allow the owners to feel the gains from big market increases because of the cap that is placed on the returns. For instance, if the market gains 50 percent, the fixed annuity investor will have a return no greater that the cap that is place, for example 4-6%.
Investors of fixed annuities would be advised to compare products based on their need and the benefits provided by specific products. After finding the right annuity, it may serve as a well-deserved retirement tool for those are looking for a conservative investment with principal protection, participation in market returns and other product specific features like income. It is ideal for those who are seeking safety and a future benefit when the client has reached retirement age.
Annuities are best suited for long term investors. Any withdrawal prior to age 59 ½ is subject to a 10% tax penalty as well as regular income tax. Annuities often also have a surrender schedule, meaning that withdrawals may be subject to a penalty by the insurance company if not left in for a predetermined amount of time. Any guarantees on principal invested are based upon the claims paying ability of the underlying insurance company.