What is an Equity Indexed Annuity
An equity-indexed annuity is an annuity that earns interest that is linked to a stock or other equity index. One of the most commonly used indices is the Standard & Poor's 500 Composite Stock Price Index (the S&P 500).
HOW ARE THEY DIFFERENT FROM OTHER FIXED ANNUITIES?
An equity-indexed annuity is different from other fixed annuities because of the way it credits interest to your annuity's value. Most fixed annuities only credit interest calculated at a rate set in the contract. Equity-indexed annuities credit interest using a formula based on changes in the index to which the annuity is linked. The formula decides how the additional interest, if any, is calculated and credited. How much additional interest you get and when you get it depends on the features of your particular annuity.
Your equity-indexed annuity, like other fixed annuities, also promises to pay a minimum interest rate. The rate that will be applied will not be less than this minimum guaranteed rate even if the index-linked interest rate is lower. The value of your annuity also will not drop below a guaranteed minimum. For example, many single premium annuity contracts guarantee the minimum value will never be less than 90 percent (100 percent in some contracts) of the premium paid, plus at least 3% in annual interest (less any partial withdrawals). The insurance company will adjust the value of the annuity at the end of each term to reflect any index increases.
WHAT ARE SOME OF THE CONTRACT FEATURES?
Two features that have the greatest effect on the amount of additional interest that may be credited to an equity-indexed annuity are the indexing method and the participation rate. It is important to understand the features and how they work together.
The indexing method means the approach used to measure the amount of change, if any, in the index. Some of the most common indexing methods include annual reset (ratcheting), high-water mark and point-to-point.
The participation rate decides how much of the increase in the index will be used to calculate index-linked interest. For example, if the calculated change in the index is 9% and the participation rate is 70%, the index-linked interest rate for your annuity will be 6.3% (9% x 70% = 6.3%). A company may set a different participation rate for newly issued annuities as often as each day. Therefore, the initial participation rate in your annuity will depend on when it is issued by the company. The company usually guarantees the participation rate for a specific period (from one year to the entire term). When that period is over, the company sets a new participation rate for the next period. Some annuities guarantee that the participation rate will never be set lower than a specified minimum or higher than a specified maximum.
Cap Rate or Cap
Some annuities may put an upper limit, or cap, on the index-linked interest rate. This is the maximum rate of interest the annuity will earn. In the example given above, if the contract has a 6% cap rate, 6%, and not 6.3%, would be credited. Not all annuities have a cap rate.
Floor on Equity Index-Linked Interest
The floor is the minimum index-linked interest rate you will earn. The most common floor is 0%. A 0% floor assures that even if the index decreases in value, the index-linked interest that you earn will be zero and not negative.
HOW DO I KNOW WHICH EQUITY-INDEXED ANNUITY IS BEST FOR ME?
As with any other insurance product, you must carefully consider your own personal situation and how you feel about the choices available. No single annuity design may have all the features you want. It is important to understand the features and trade-offs available so you can choose the annuity that is right for you. Keep in mind that it may be misleading to compare one annuity to another unless you compare all the other features of each annuity. You must decide for yourself what combination of features makes the most sense for you. Also, remember that it is not possible to predict the future market behavior of an index.
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 is based upon the claims paying ability of the underlying insurance company.