Fixed annuities promise an income based on current interest rates, which are low. An annuity company can help you make the right decisions by offering a variety of products. Experiencing a long retirement horizon, you may want to take into account relying a little on the markets (i.e. rising interest rates) to boost you annuity income. Equity-indexed annuities offer that opportunity, but you must understand how it works. An annuity company will provide a selection of such annuities that might fit your need for growing income or principal.
Equity-indexed annuities combine options that come with traditional insurance products (guaranteed minimal return) and traditional securities (where the return is linked to equity markets).
Here's how equity index annuities work:
During the build up period - when you help to make either a lump sum payment or a number of payments - your annuity company provides you with a return depending on changes in an equity index. The Standard and Poors 500 index is a typical index (the S&P 500 is an unmanaged index of 500 with the largest capitalization US shares and cannot be invested in immediately).
The annuity company typically guarantees the absolute minimum return of 2.5% annually even if the S&P 500 remains unchanged or flat during the entire term of the annuity. Annuity companies offer terms from 5 years to 20 years and you select a term that fits your retirement needs. Surrender costs (charges to cash in your annuity prior to the term) can last for several years. It is possible to lose money and lose any index-related gains if the policy holder cancels the policy in the early years. If there is zero increase in the underlying index during the selected term, investors receive merely the minimum guaranteed rate minus withdrawals. Note that any annuity company provides such product as a retirement tool and withdrawals prior to age group 59 ½ are subject to 10% IRA penalty.
After the accumulation period, the particular equity indexed annuity company will make periodic payments for you unless you take you take the contract value as a one time payment. Most people opt for the annuity company to make payments over time to spread out the tax impact.
Understanding how the interest rate used in your current contract is linked to the equity index establishes what advantage you really overcome as compared to a traditional fixed annuity. Consider these procedures within the interest crediting process.
Annuity Company contract features
The participation rate determines what amount of the index's increase will be used to calculate the index-linked interest rate. For example, if the participation rate is 75% and the index increases 10%, your return credited to your annuity would be 7.5% (10% x 75% = 7.5%).
Interest Rate caps set a maximum rate of interest that the equity-indexed annuity can gain during a set period such as a year. If a contract has an maximum, or cap, of 7% and the index linked to the annuity gained 7.5%, merely 7% would be credited by the annuity company.
The particular Margin, Spread or Management Fee is a subtraction of a 'fee' percentage from any grow in the index. This fee might be called the 'margin,' 'spread,' or 'administrative fee.' An annuity company taking a 'spread' of 3%, will credit a return of only 7% if the index received 10% (i.e. 7% = 10% -- 3%).
A couple of indexing methods include:
Annual Reset (or Ratchet). This process (learn more from your annuity company) credits index-linked interest based on any growth in index value from the beginning to the end of the year. Your annuity company can provide more information. id the index declines the next year, your gain from the first year is locked in.
Point-to-Point. This method credits index-linked interest for the period from the beginning of the annuity to the end of the term, with no gains locked in mid-term.