What is an Equity Index Annuity (EIA)?
An equity index annuity (EIA) is a type of savings or investment plan that provides for either immediate or deferred payouts. Returns are linked to a stock market index (often the S&P 500 or the Dow Jones Industrial Average) performance.
Indexed annuities were first introduced by insurance companies in the 1990’s mainly for retirees or those nearing retirement to help provide protection and provide growth for their retirement money. These investments are linked the performance of a stock market index, but offer some downside protection for those that may not have time to recuperate from market losses.
These annuities can be purchased from an insurance company, and similar to other types of annuities (fixed and variable), the terms and conditions associated with payouts will depend on what is stated in the original annuity contract. It is important to understand the tradeoffs and various features when considering purchasing an indexed annuity.
Surrender period and charges are important to consider before purchasing an indexed annuity. A surrender period is the length of time in which you will incur a penalty if you move your money away from the particular insurance company. These will usually range from 3-15 years. It is necessary for an insurance company to have surrender charges on their contracts because they have various expenses in which they are incurring in order to deliver the product to you. Be sure you understand the surrender period and any charges that may be applicable with the annuity before purchasing.
How interest is credited to these types of annuities will vary depending upon the contract. As mentioned earlier, the interest one earns in an indexed annuity is linked to a specific stock market index. However, in order to offer the downside protection, there is a tradeoff. Some annuities will have caps on how much an investor may gain, some will have “spreads,” and some may have participation rates.
A cap is simple to understand. Let’s just say that an annuity has a cap of 7%. This means that if the index gains 10% in one year, the annuity will only credit up to 7% of the that gain. However, if the index lost 10% one year, it would credit 0%, rather than going backwards 10%.
A “spread” functions a little differently. Let’s assume that an annuity has a 4% spread. That means that if the index gains 10%, the first 4% is the spread, so the annuity would only be credited the difference; in this case, 6%.
A participation rate is different than the above two examples. Let’s suppose that an annuity has a 30% participation rate. If the index goes up 10%, the annuity will credit 30% of that growth, which would be 3%.
As you can see, there are many different ways an indexed annuity may credit interest. In addition, there are a number of different stock market indices that may be considered for use inside of a contract. It is important for you to carefully evaluate the options inside of an indexed annuity before making your decision to purchase one. They can be a valuable retirement planning tool, but they are certainly complex. Don’t be afraid to ask questions so you can clearly understand the annuity you are purchasing.
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.