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Equity Indexed Annuity

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In the early 1990s, someone at an insurance company had a creative idea. The idea was to combine the gains of the stock market with the guarantees of a fixed annuity. Why? Well, in short, people did not want to risk their money in the market, and they wanted higher potential returns than a traditional fixed annuity.

The other two types of annuities, variable and fixed, are much more easy to understand. Variable annuities are the purchase of mutual funds under the umbrella of an annuity, and fixed annuities are like bank CDs that pay a fixed interest rate (which can go and up down, but has a guarantee attached to it, such as 3% annually).

If you want to know more about Equity-Indexed Annuities (now referred to as EIA), please read on.
There are basically 2 components of an EIA, an "index" and the "administrative pieces".

The index component is simple. In the most basic terms, the index is the financial index that your money will be tracking. Most EIAs track the S&P 500 index. Some companies use additional indexes such as the Dow Jones Industrial Average (DJIA), the NASDAQ-100, the Lehman Index, the Russell 2000, the Merrill Lynch Bond Index, and possibly some others. Tracking means that if the financial index goes up 1%, then your investment is given a 1% credit of interest. For example, if you invested $100,000 and the index went up 1%, then your investment would receive a 1% interest credit or $1,000.

The administrative pieces component is incredibly complex and varies with each insurance company. The common administrative pieces are a "Cap", "Crediting type", "Bonus", "Term", "Annuitization Options", "Fees", "Spread", "Participation Rate", "Surrender Charges", and "Free Withdrawals". If you have done some research, you may know what many or all of these already are. That is great! You are ahead of the game. For everyone else, we will go over these in detail below.

CAP A Cap is the ceiling on how much interest you can earn in a given year. This is one way the insurance company can make money. If you have an anuity with a cap of 10% with your money tracking the S&P 500 index, and the S&P 500 index goes up 20% in one year, then you will get paid 10% instead of the full 20%. Almost all EIAs have some sort of cap, and the caps can change. The insurance company may initially have a 10% cap on your annuity, but may increase it to 13% because their competitors are increasing their own. Conversely, your cap may be decreased if the market is doing poorly and everyone else is decreasing their caps. Fortunately, most annuities have a guaranteed cap of 5% or more, which means your cap can never be decreased below 5%.

CREDITING TYPE The crediting type is a critical piece of an EIA. This determines how your index gains are calculated and credited over time. The common terms associated with crediting type are "Point to Point", "Monthly Averaging", and "Annual Reset".

Annual Reset means that on the anniversary date of your annuity (the date your policy is effective), the index you are tracking resets. For example, if you are tracking the S&P 500 and the day you purchased the annuity, the index had a value of 1000 and over the course of the next year, it increased to 1100 or 10%. On your anniversary date, the index is now reset to 1100 and you get to keep the 10% gains forever. If over the course of the next year the index drops from 1100 to 900, you will not lose anything, but on your anniversary date, your money is re-invested at a value of 900. This is important so that when the index goes down, you are able to make significant gains in the following years. Here is a visual example:

Purchase Date Year 1 Year 2 Year 3 Year 4 Year 5 S&P Index Value 1000 1100 900 950 1100 1050 Index credits 0 10% 0 5% 15% 0%

Point to Point means that index gains are calculated every year, from anniversary date to anniversary date (or in the case of monthly point to point, the monthly gain or loss is added up over the course of the year and crediting on your anniversary date). In other words, if the index over the course of the year gained 5%, then you earn 5%. However, if the market was great for 10 months, but then lost all of its gains over the following 2 months and ended up with 0% growth, then you earn 0%. Point to Point requires you to "time the market" as they say, so that your investment grows when the market grows over the course of an entire year.

Monthly Averaging means that index vales are averaged each month over the course of 12 months. This helps fight the volatility of the market and enables the investment to make earnings without having to time the market. You may start or end at the wrong time for the index, but you actually have participated throughout the year, so you are less dependent on trying to time the market.

BONUS Many insurance companies are now offering a "bonus" interest rate when you purchase the annuity. This bonus can be immediately reflected on your account or spread out over time, depending on the structure of the annuity. For example, if you purchase a $100,000 annuity and the product has a 5% immediate bonus, the insurance company automatically adds $5,000 to your account. Some companies may decide to give you the 5% bonus spread out over 5 years or 1% yearly. Bonus products are a great feature to give you an immediate return on your investment, especially in a low-interest rate marketplace like today.

TERM The term of the annuity is the contract length, meaning how long you are committing to staying with the particular company and annuity. You usually are able to get out of the contract early, but that would require surrender charges and possibly other penalties, such as loss of previously earned bonus or interest.

SURRENDER CHARGE The surrender charges in any annuity is the amount your account will be reduced if you decide to terminate your contract. These charges typically decrease over time, starting at a high rate and finishing at a low rate. For example, if your annuity has a surrender charge schedule of 10%,9%,8%,7%,6%,5%,4%,3%,2%,1% over 10 years and you decide to terminate your contract in year 2, your account will be deducted 9% of the remaining balance. Surrender charges in EIAs can be very high (I have seen as high as 25%), so it is very important that you pay close attention to them and make sure that they are acceptable in case you do need to terminate your contract.

ANNUITIZATION OPTIONS Options for annuitization are basically your options to convert the annuity so that you begin receiving income payments. The caveat with some EIAs is that you must choose an annuitization option in order to fully access your money - in other words, there are no surrender charges and the only way to get out of your contract is to receive income periods over a specific time period. Look closely at this component of your EIA, especially if you have no need for income in the foreseeable future and would simply like to see your anniuty build in value. There are a number of options for annuitization, including income for life, interest only, period certain, period certain or life - look closely at the EIA specifics to see which options are available.

FREE WITHDRAWALS While you may be committing to a contract for a specified number of years, you should always be able to access some of your money "penalty free" or "free of surrender charges". Most EIAs allow you to withdrawal 5-10% of your account balance annually. For example, if you have a $100,000 annuity, and a 10% free withdrawal provision, then you can take out up to $10,000 each year without paying any surrender charges. If you may need a portion of your annuity balance in the future, make sure you find an EIA with at least a 10% free withdrawal annually.

FEES Fees associated with an EIA are no different than those associated with other annuities. A fee is a fixed amount or percentage that is taken out of your account by the insurance company every year to cover their "administrative expenses". Because of the high competition among insurance carriers in today's marketplace, there are fewer annuities that charge fees, but they are still out there. Most EIAs do not have these types of fees (as opposed to variable annuities, which all do).

SPREADS (also called MARGIN by some companies) A spread is the rate the company charges on your index return. For example, if the EIA has a 2% spread and you earned 10% for the year, then you are actually given 8% interest and the company takes the other 2%. The spread is similar to a fee except that you are not charged a spread if your account does not increase in a yearly period. However, just as with fees, spreads are taken on your account every year.

PARTICIPATION RATE The participation rate of an EIA is the percentage of market gains you will receive. For example, if the participation rate is 100% and the index you are tracking goes up 10%, then your account will grow by 10% (assuming no caps, spreads or fees). If the participation rate is 50% and the index you are tracking goes up 10%, then your account will grow by 5% (assuming no caps, spreads or fees).

This article is licensed under the GNU Free Documentation License. It uses material from the Wikipedia article "Equity Indexed Annuity".