What Are Equity-Indexed Annuities?

Indexed annuities are a special class of annuities that have the potential to earn higher yields than fixed annuities because their performance is tied to a market index, such as the S&P 500.* An equity-indexed annuity (EIA) is not a security but rather is classified as a single-premium traditional annuity. It must meet the strict insurance department requirements for interest guarantees as well as guarantees against loss of principal, and it provides traditional annuity benefits.

No-Loss Provision

The first and possibly most-attractive provision of equity-indexed annuities is the no-loss provision. This provision guarantees that once a premium payment has been made or interest has been credited to the account, the value of the account cannot decrease below that level. This provides safety from the volatility of the market index to which the annuity is linked. Of course, any guarantees are contingent on the claims-paying ability of the issuing company.

Interest Guarantees

The interest guarantees also appeal to many people. Most contracts have a cap (the maximum interest rate that can be credited to an annuity in a contract year) and a floor (the minimum interest rate that can be credited in a contract year). The cap rate can vary from no cap to a fixed percentage, but the floor is generally zero. This allows the contract holder to benefit from potentially high returns and, at the same time, be guaranteed that no money will be lost.

Traditional Annuity Benefits

Equity-indexed annuities offer many of the same benefits as traditional annuities, including tax-deferred accumulation.

Remember that most annuities have surrender charges that are assessed in the early years of the contract if the owner surrenders the annuity before the company has had the opportunity to recover its costs. The earnings portion of withdrawals is taxable as ordinary income, and withdrawals made prior to age 59½ are also subject to a 10% federal income tax penalty.

Equity-indexed annuities typically offer other benefits that are not generally included in traditional policies. EIA values fluctuate with changes in market conditions.

Of course, EIAs are not appropriate for every investor. Participation rates are set and limited by the insurance company. So an 80% participation rate means that only 80% of the gain experienced by the index for that year would be credited to the contract holder. The guarantees of indexed annuities may cover only a certain percentage of the initial investment; therefore, it is possible to lose money when investing in an EIA.

Also, like most annuity contracts, equity-indexed annuities have certain rules, restrictions, and expenses. Some insurance companies reserve the right to change participation rates, cap rates, the spread/asset/margin fees, and other fees either annually or at the start of each contract term. These types of changes could affect the investment return. It is prudent to review how the contract handles these issues before deciding whether to invest in an EIA.

*The S&P 500 is an unmanaged index that is considered representative of U.S. stocks. The performance of an unmanaged index is not indicative of the performance of any particular investment. Individuals cannot invest directly in an index. Past performance is no guarantee of future results.

© 2007 Emerald Publications