Should You Buy an Equity Indexed Annuity?

What us an equity indexed annuity?

Put simply, an equity indexed annuity is a contract made between the holder and an insurance company that has many special traits. It is a deferred fixed annuity with the following characteristics. An equity indexed annuity can be accrued over a set length of time, using either one single payment or a series of separate payments, and the insurance company bases the returns against an agreed equity index, such as the S&P 500.

Generally, an agreed minimum return is set, a figure that will vary from incidence to incidence. Once the accumulation period is over, that insurance company will pay your annuity as per the terms of the original contract, either in a lump sum or a series of individual payments.

The risks involved of an equity indexed annuity

Like all such investment and annuity arrangements, there are risks that you may lose money on your investment. Even though the issuing insurance company will guarantee your original principal, you could lose money if you withdraw your funds prior to the end of the term and need to pay surrender charges.

Alternatively, you may earn only the minimum guaranteed rate. If you equity indexed annuity has a guarantee rate of 3% and the market goes down during the term of your contract, you will earn only the guarantee rate.

Common equity indexed annuity features

The very nature of an equity-indexed annuity makes it a complicated opportunity, and the number of individual features of the contract affecting your return can be many. It is important that the investor is aware of all contributing factors, and how such things as interest rates and returns are computed.

The buyer would be advised to pay close attention to the participation rate, this being a method of determining the proportion of the increase in the agreed index that is used to calculate the ultimate interest rate. For example, the equity indexed annuity contract may specify that you get 50% of the increase in the S&P 500.

Equally important are interest rate caps, used to limit the amount of interest that can be applied to your equity indexed annuity. These are common features of equity indexed annuities, and can have a major effect on the eventual value of the annuity.

Investors would also be advised to pay attention to the margin, or spread or administrative fee, a payment that is based upon the difference between the gain in the annuity and the original value.

There are many further features that can affect the value and efficiency of an equity indexed annuity, and these should all be explained to the investor in detail- ‘high water marks’ for instance that take account of the peak in interest, and tools that allow rates to be reset year upon year, all of which can have a great effect on the eventual performance of an equity indexed annuity.

In our analysis, if the market advances at 11% annually, one should expect to gain 50% to 60% of this amount by a well structured equity index annuity. Given that your original principal is guaranteed (limited by the explanation above), this may be a good tradeoff of safety and opportunity for gain for a retiree.