Is An Equity Indexed Annuity A Good Idea?

With all of the ups and downs in the stock market, many investors have been asking this question, “Is there a way to make money in the stock market and still have a way not to lose my principal is the market goes down?”    While investment companies have scrambled to find different investment solutions to help the baby boomers with this particular issue, the sales of a product called an equity indexed annuity have been booming.  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).   It can be a very complex choice on whether to purchase one of these products in your portfolio.

Note: (all information below was taken directly from www.finra.org)

What is an Annuity?

An annuity is a contract between you and an insurance company in which the company promises to make periodic payments to you, starting immediately or at some future time. If the payments are delayed to the future, you have a deferred annuity. If the payments start immediately, you have an immediate annuity. You buy the annuity either with a single payment or a series of payments called premiums.

Annuities come in two types: fixed and variable. With a fixed annuity, the insurance company guarantees both the rate of return and the payout. As its name implies, a variable annuity’s rate of return is not stable, but varies with the performance of the stock, bond and money market investment options that you choose. There is no guarantee that you will earn any return on your investment and there is a risk that you will lose money. Unlike fixed contracts, variable annuities are securities registered with the Securities and Exchange Commission (SEC).

What is an Equity-Indexed Annuity?

EIAs are complex financial instruments that have characteristics of both fixed and variable annuities. Their return varies more than a fixed annuity, but not as much as a variable annuity. So EIAs give you more risk (but more potential return) than a fixed annuity but less risk (and less potential return) than a variable annuity.

EIAs offer a minimum guaranteed interest rate combined with an interest rate linked to a market index. Because of the guaranteed interest rate, EIAs have less market risk than variable annuities. EIAs also have the potential to earn returns better than traditional fixed annuities when the stock market is rising.

What is the Guaranteed Minimum Return?

When EIAs were first sold in the mid-1990s, the guaranteed minimum return was typically 90 percent of the premium paid at a 3 percent annual interest rate. More recently, in part because of changes to state insurance laws, the guaranteed minimum return is typically at least 87.5 percent of the premium paid at 1 to 3 percent interest. However, if you surrender your EIA early, you may have to pay a significant surrender charge and a 10 percent tax penalty that will reduce or eliminate any return.

How good is this guarantee?

Your guaranteed return is only as good as the insurance company that gives it. While it is not a common occurrence that a life insurance company is unable to meet its obligations, it happens. There are several private companies that rate an insurance company’s financial strength. Information about these firms can be found on the SEC’s website.

What is a market index?

A market index tracks the performance of a specific group of stocks representing a particular segment of the market, or in some cases an entire market. For example, the S&P 500 Composite Stock Price Index is an index of 500 stocks intended to be representative of a broad segment of the market. There are indexes for almost every conceivable sector of the stock market. Most EIAs are based on the S&P 500, but other indexes also are used. Some EIAs even allow investors to select one or more indexes.

How is an EIA’s index-linked interest rate computed?

The index-linked gain depends on the particular combination of indexing features that an EIA uses. The most common indexing features are listed below. To fully understand an EIA, make sure you not only understand each feature, but also how the features work together since these features can dramatically impact the return on your investment.

  • Participation Rates. A participation rate determines how much of the gain in the index will be credited to the annuity. For example, the insurance company may set the participation rate at 80 percent, which means the annuity would only be credited with 80 percent of the gain experienced by the index.
  • Spread/Margin/Asset Fee. Some EIAs use a spread, margin or asset fee in addition to, or instead of, a participation rate. This percentage will be subtracted from any gain in the index linked to the annuity. For example, if the index gained 10 percent and the spread/margin/asset fee is 3.5 percent, then the gain in the annuity would be only 6.5 percent.
  • Interest Rate Caps. Some EIAs may put a cap or upper limit on your return. This cap rate is generally stated as a percentage. This is the maximum rate of interest the annuity will earn. For example, if the index linked to the annuity gained 10 percent and the cap rate was 8 percent, then the gain in the annuity would be 8 percent.

Caution! Some EIAs allow the insurance company to change participation rates, cap rates, or spread/asset/margin fees either annually or at the start of the next contract term. If an insurance company subsequently lowers the participation rate or cap rate or increases the spread/asset/margin fees, this could adversely affect your return. Read your contract carefully to see if it allows the insurance company to change these features.

Indexing Methods. As described in the table below, there are several methods for determining the change in the relevant index over the period of the annuity. These varying methods impact the calculation of the amount of interest to be credited to the contract based on a change in the index.

Indexing Method Description
Annual Reset (Rachet) Compares the change in the index from the beginning to the end of each year. Any declines are ignored.Advantage: Your gain is “locked in” each year.Disadvantage: Can be combined with other features, such as lower cap rates and participation rates that will limit the amount of interest you might gain each year.
High Water Mark Looks at the index value at various points during the contract, usually annual anniversaries. It then takes the highest of these values and compares it to the index level at the start of the term.Advantage: May credit you with more interest than other indexing methods and protect against declines in the index.Disadvantage: Because interest is not credited until the end of the term, you may not receive any index-link gain if you surrender your EIA early. It can also be combined with other features; such as lower cap rates and participation rates that will limit the amount of interest you might gain each year.
Point-to-Point Compares the change in the index at two discrete points in time, such as the beginning and ending dates of the contract term.Advantage: May be combined with other features, such as higher cap and participation rates, that may credit you with more interest.Disadvantage: Relies on single point in time to calculate interest. Therefore, even if the index that your annuity is linked to is going up throughout the term of your investment, if it declines dramatically on the last day of the term, then part or all of the earlier gain can be lost. Because interest is not credited until the end of the term, you may not receive any index-link gain if you surrender your EIA early.
  • Index Averaging. Some EIAs average an index’s value either daily or monthly rather than use the actual value of the index on a specified date. Averaging may reduce the amount of index-linked interest you earn.
  • Interest Calculation. The way that an insurance company calculates interest earned during the term of an EIA can make a big difference in the amount of money you will earn. Some EIAs pay simple interest during the term of the annuity. Because there is no compounding of interest, your return will be lower.
  • Exclusion of Dividends. Most EIAs only count equity index gains from market price changes, excluding any gains from dividends. Since you’re not earning dividends, you won’t earn as much as if you invested directly in the market.

Can I get my money when I need it?

EIAs are long-term investments. Getting out early may mean taking a loss. Many EIAs have surrender charges. The surrender charge can be a percentage of the amount withdrawn or a reduction in the interest rate credited to the EIA.

Also, any withdrawals from tax-deferred annuities before you reach the age of 59½ are generally subject to a 10 percent tax penalty in addition to any gain being taxed as ordinary income.

Do EIAs and other tax-deferred annuities provide the same advantages as 401(k)s and other before tax retirement plans?

No, 401(k) plans and other before-tax retirement savings plans not only allow you to defer taxes on income and investment gains, but your contributions reduce your current taxable income. That’s why most investors should consider an EIA and other annuity products only after they make the maximum contribution to their 401(k) and other before-tax retirement plans. To learn more about 401(k)s, please read Smart 401(k) Investing.

Is it possible to lose money in an EIA?

Yes. Many insurance companies only guarantee that you’ll receive 87.5 percent of the premiums you paid, plus 1 to 3 percent interest. Therefore, if you don’t receive any index-linked interest, you could lose money on your investment. One way that you could not receive any index-linked interest is if the index linked to your annuity declines. The other way you may not receive any index-linked interest is if you surrender your EIA before maturity. Some insurance companies will not credit you with index-linked interest when you surrender your annuity early.   Note: (all of the information above was taken directly from www.finra.org)

As with any products, you need to have the right financial advice around the companies that offer the best products with the best features and benefits for your situation.  For more information to learn about different contracts where you can have upside potential without having downside risk, please e-mail Ted Jenkin or call our offices at 800-355-9318.

Written by:

Ted Jenkin, CFP®, AAMS®, AWMA®, CRPC®, CMFC®, CRPS®

Co-CEO and Founder oXYGen Financial, Inc

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About the author  ⁄ Ted Jenkin @ Your Smart Money Moves

Ted Jenkin @ Your Smart Money Moves

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Ted Jenkin is a frequent guest columnist for the Wall Street Journal and Headline News Weekend Express. He is the co-CEO of oXYGen Financial. You can follow him on LinkedIn @ www.linkedin.com/in/theceoadvisor or on Twitter @tedjenkin.

Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. oXYGen Financial is not affiliated with Kestra IS or Kestra AS. Kestra IS and Kestra AS do not provide tax or legal advice.

The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor regarding your individual situation. 

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3 Comments

  • September 23, 2011

    Given the high fees and limits on index participation in some cases I suggest that investors tread very very carefully here. Additionally these types of products have been on the radar screen of regulators in recent years.

  • Ted Jenkin
    Ted Jenkin Author
    September 23, 2011

    I couldn’t agree more!!!

    Ted Jenkin, CFP®, AWMA®, CRPC®, AAMS®, CMFC®, CRPS®
    Co-CEO and Founder
    oXYGen Financial, Inc.

  • January 2, 2012

    The annuity description was helpful, but how can such a relationship not allow for EIAs withdrawal?
    I mean if I decide I want to get my money out why should I suffer a penalty?

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