What are Equity-Indexed Annuities?
An equity-indexed annuity, or EIA for short, is a type of annuity that generates returns based on the performance of an underlying market index, like the stock market index. The most common index used is the Standard & Poors 500 Composite Stock Price Index (S&P 500). EIA’s provide investors with an asset that has excellent features. EIA’s offer a market tied investment with upside potential and a guaranteed minimum return. While your upside potential is limited if the market outperforms expectations, your downside risk is limited even more.
Equity-indexed annuities fall under the broad category of fixed annuities. This is because you can make a reasonable return from earnings while maintaining the ability to defer taxes on income gains. In contrast, variable annuities allow you to choose how to allocate your money in a wide variety of mutual funds; giving you the potential for higher returns but at a higher level of risk.
What makes Equity-Indexed Annuities different than other annuities?
An equity-indexed annuity is unique due to the manner in which interest earned is applied to your annuity’s growth. Most commonly fixed annuities will credit interest earned at a rate specified in your annuity contract. Also, some fixed annuities will adjust the interest rate periodically via a formula. Equity-indexed annuities will adjust interest earned based on how well the index which it is tied to performs. The equity-linked formula dictates how adjustments to interest are made. How often the adjustment occurs will depend on the details of your individual contract.
Equity-indexed annuities are a form of fixed annuities. They also guarantee a portion of the earnings to be based upon a minimum rate of interest. The earnings will not fall below the minimum guaranteed rate even if the index-linked portion does not perform well when the insurance company makes periodic adjustments to the rate.
How is EIA’s interest rate calculated based on Indices?
The earnings are calculated based on an index-linked formula. The formula used will depend on your specific annuity contract. The most common variables found in contracts are:
- Participation Rates – The participation rate sets the foundation for how much a movement in an index will cause a movement in the value of the annuity. For example, if your contract specifies a 50% participation rate then that means that the annuity would only benefit with 50% of the appreciation by the index toward the increase in valuation of the annuity.
- Spread/Margin/Asset fee – Instead of the participation rate some EIA’s might incorporate a spread, margin or asset fee. This will be a percentage specified in the contract that will be subtracted from any appreciation in the underlying index that the EIA is linked to. For example, if the linked index appreciated by 10 percentage points and the spread/margin/asset fee is 4 percentage points then the appreciation of the annuity would be 6 percent.
- Interest Rate Caps – Another method used to adjust the returns of EIA’s are interest rate caps. This is an upper limit on the earnings of your EIA expressed as a percentage. It will define the maximum amount of return that the annuity will earn. For example, if the underlying index linked to the annuity appreciated by 12 percent and the cap rate was set at 10 percent, then the appreciation of the annuity would be 10 percent.
- Interest Rate Floor – The index rate floor would be the minimum rate you will earn. It is common to include a 0% floor appreciation rate. This is done to guarantee that even if the underlying index were to depreciate in value you will not incur a negative rate of growth. Not all annuities will have a floor rate, but your fixed annuity will still have the minimum guaranteed value
Over the term of your annuity contract, the rate will change over a given period of time. The method used to determine the term and the rate of change in the rate of return of your index-linked annuity is based on the indexing method it utilizes. The following are the most common forms of indexing methods used by Equity Indexed Annuities.
- Annual Reset (Rachet) – This method is the simplest. It will compare the variation between the beginning and the end of each period. If the result is a negative value, then it will be discarded. This is widely used since gains will be “locked in” periodically. Another downside to this method is that it might be combined with other features that will decrease gains. For example, the cap rates and participation rates might be lower in annuities that utilize this indexing method. This will limit the appreciation of the interest rate that you would get.
- High Water Mark – This method annualized the value of the index at certain points during the open contract period. The most common method is using annual reviews to determine the value based on the past year as a whole. Since this method looks for the high point during the entire review period it may provide a higher increase compared to the other indexing methods and protect against declines. But, since the interest is only determined periodically you might miss out on some gains if the highest level occurred early on in the open review period.
- Point-to-Point – This method will compare the rate at two specified periods of time. For example, at the beginning and ending dates of the annuity contract period. Many investors like that it can be combined with other features, like a higher cap and participation rate, which would provide more appreciation. Although, since it relies on a single point in time to evaluate the interest rate a substantial appreciation in the underlying indices during most of the period but a sudden drop at the end will result in diminished returns. Since the interest rate is not evaluated until the set date.
- Averaging – Index averaging will take the average value of the index, either daily or monthly, throughout the period instead of picking specific dates. This method is good at protecting you from being harmed by sudden drops in the market at the end of the period.
Benefits of the Equity-Indexed Annuity
- No-Loss Provision: Possibly the best provision of an equity-indexed annuity is the no-loss provision. This provides guarantees when faced with a volatile underlying index. Once an interest rate has been locked into the value of the annuity contract, a decline in the index will not result in a decrease of the interest rate of the annuity.
- Interest Rate Guarantees – Most equity-indexed annuity contracts contain an interest rate floor. This floor is usually expressed as 0%. This means that a decline in the underlying index will not mean a reduction in interest earned by the annuity contract.
- Competitive rates of return – Especially when compared to leaving your money in CDs or US Treasuries, equity-indexed annuities provide a great form of investing. When viewing the long term appreciation of market indices, the potential for substantial earnings increases significantly.
Learning about the intricacies of equity-indexed can seem quite complicated due to all the different clauses available to the contracts. The point to remember is that it does offer upside potential like if you invested in the stock market and the option to eliminate downside risk. This is an important feature for many investors who are planning for long-term asset allocation. Should you have any questions about any of the features of an equity-indexed annuity please speak with a licensed financial professional or contact us directly with your questions.