An annuity is a contract between an individual and an insurance company in which the purchaser, or annuitant, makes either a lump-sum payment, or series of payments, in return for a guaranteed income at a later date. Equity indexed annuities (EIA)s are annuities whose returns are based upon the performance of a specified equity market index. While annuities are available in several countries, the EIA is only available in the United States.
In the US, fixed annuity contracts are considered insurance products not subject to Security Exchange Commission (SEC) regulation. Variable annuities, on the other hand, are invested in mutual funds and do come under SEC supervision. Equity indexed annuities are a hybrid which generally are not considered securities. Like fixed annuities, they offer a minimum guaranteed return, usually 90% of the premiums paid, plus at least 3% interest. By linking the return rate to an equity index, they also provide an opportunity to profit from market upswings without the risks of variable annuities.
An equity index tracks the performance of a particular group of stocks related to the same sector of the stock market or economy. In the US, some of the larger indices include the Dow Jones Industrial Average (DJIA), the S&P Composite Stock Price Index, and the NYSE Composite Index, among others. Before purchasing an EIA, a person should investigate the performance of the index tied to the annuity.
The amount of return paid by equity indexed annuities is not necessarily the same as the actual index’s gain. Most EIA contracts include a participation rate, which is the percentage of gain that will be used to calculate the return. For example, if the contract has an 80% participation rate, and the index increases 10%, then the annuity will only pay 8% (80% of 10% = 8%). Some contracts also include a maximum, or cap. If the cap is 7%, and the index increases 10%, the maximum rate paid will be 7%.
Another limiting factor is the margin / spread / administration fee charged by some equity indexed annuities. This is a percentage of the index gain retained by the insurance company. If a contract has a 3.5% spread and an index grows at 9%, the maximum rate paid by the annuity will be 5.5% (9% - 3.5% = 5.5%). Some EIA contracts allow the insurance company to periodically change participation rates, caps and spreads.
How the amount of change in the linked index is calculated is another important factor in determining potential gain from equity indexed annuities. Some calculate change annually. Any loss is ignored, but any gain is locked in and credited to the account. This can be advantageous as long as the contract does not have low caps and participation rates.
Another method of calculating index gains is the point-to-point method. This generally compares the index values at the beginning and ending dates of the contract. If there is a net gain, that is the amount paid, subject to any other contract limitations. A significant disadvantage occurs if the index had done well during intervening years, but dropped immediately prior to the end date, resulting in no benefit to the annuitant.
The high water mark method of determining index gain may give the best rate of return. This method records values at the beginning of the contract period and at various benchmarks throughout the contract term. The highest point is then used to calculate the index gain. As long as a person does not need to surrender his annuity early, and does not have low caps or participation rates, then equity indexed annuities using this calculation are the most advantageous.
Equity indexed annuities are intended to be held long-term, and usually carry significant surrender charges. The fees are phased out over time, but can take 10 to 15 years to be completely eliminated. Early surrender could actually result in the loss of a portion of the initial payment. For this reason, these are not considered an appropriate vehicle for most senior investors.
Young investors with enough capital to not worry about needing an early withdrawal may find equity indexed annuities viable options. They offer the benefits of a guaranteed minimum return, plus the opportunity to benefit from stock market increases, without the associated risks. These can be rather complicated products, however, so an investor should be very careful to examine all of the contract terms.