Equity index annuity

Equity-indexed annuity

An equity index annuity in the United States is a type of tax-deferred annuity whose credited interest is linked to an equity index --SEE EXAMPLE HERE>> , and typically uses the S&P 500 or international index. It guarantees a minimum interest rate (typically no less than 3%) and protects against a loss of principal. An equity index annuity is a contract with an insurance or annuity company. The returns may be higher than fixed instruments such as CDs, money market accounts, and bonds but not as high as market returns. Equity Index Annuities are not FDIC insured and are subject to the risk of default by the issuing company.

The contracts may be suitable for a portion of the portfolio for those who want to avoid risk and are in retirement or nearing retirement age. The objective of purchasing an equity index annuity is to realize greater gains than those provided by CD's, money markets or bonds, while still protecting principal. The long term ability of Equity Index Annuities to beat the returns of other fixed instruments is a matter of debate.

Indexed annuities represent about 30% of all fixed annuity sales in 2006 according to the Advantage Group (see www.indexannuity.org)

Equity Indexed Annuities may also be referred to as Fixed Indexed Annuities or simple indexed annuity. The mechanics of how Equity Index Annuities work are often complex and the returns can vary greatly depending on the month and year the annuity is purchased. Like many other types of annuities, equity-indexed annuities usually carry a surrender charge for early withdrawal. These "surrender periods" typically range between 5 and 20 years.

A Different way to Credit Interest

The indexed annuity is virtually identical to a fixed annuity except in the way interest in calculated. As an example consider a $100,000 fixed annuity that credits a 4% annual effect interest rate. The owner then receives an interest credit of $4000. However, in an equity indexed annuity the interest credit is linked to the equity markets. For example assume the index is the S&P 500 and a one year point-to-point method is used and that the annuity offers a 8% cap. The $100,000 annuity could credit anything between 0% and 8% based on the change in the S&P 500.

This allows the owner the security of knowing that the $100,000 is safe but that rather than receiving the sure 4% they can receive up to 8%. Historically since 1950, an 8% cap on the S&P 500 has result in an average interest credit of 5.2%, very similar to what is considered the "risk free rate of return" delivered by T-bills, 5.1% over a similar period. The return may also be adjusted by other factors such as the participation rate and market value adjustments to cover costs to the insurance company.

This means the owner of the indexed annuity now has assumed more risk than a fixed annuity but less than being in the equity markets themselves. The result is that the expected yield (risk adjusted) for an indexed annuity is higher than a fixed annuity, CD, etc. However, the expected yield of being in the market is higher for several reasons.

The principal (in our example the $100,000) is at risk of loss when owning the index outright. The Equity Index Annuity does not create dividends as the index does. Therefore there is not reinvestment taking place inside the annuity. The ability to compound returns may occur as infrequently as once every two years (when interest is actually credited to the account) instead of daily within the index itself. And some of the gains when owning the index are taxed at a capital gains rate, currently lower than the ordinary income rate incurred on all annuity gains.

This way of linking to an equity index like the S&P 500 or Dow Jones is accomplished through an option, usually a call option. A call option is the right but not the obligation to purchase something at a future date for a specified price.

The naming conventions for options used by the insurance industry is different than that of Wall Street but the options are structurally identical. Here's a sample of options commonly seen in indexed annuities.

  • Insurance vs. Wall Street
  • Point-to-Point vs. European
  • Monthly Average vs.Asian
  • Monthly Point-to_Point vs. Cliquet
  • Performance Triggered vs. Binary

The options in indexed annuities can usually be fit into the following taxonomy developed by the National Association of Fixed Annuities.

Term - the length of time before option matures, usually one year. Two, three, four, and ten are also prevalent in the market. Some longer term options are but have a "highwater" feature that allows interest to be credited more frequently. An example of this would be a ten year Monthly Average option that credits interest each year if there is a gain.

Index - the equity, stock, bond, or other index to which the interest credit is linked.

Gain Formula - the method used to determine the gain in the index. Point to point, monthly averaging, daily averaging are the most common methods of calculating the gain. For example of the S&P 500 index starts at 1120 and ends at 1300 then the point to point gain is 16.07%.

Adjustment Method - the way the option is limited in order to reduce the cost (and subsequent return) so that it becomes affordable. As an example the point to point option may cost 7% of the account value but will be "adjusted" to reduce the cost.

"Market Value Adjustment" - the company may reserve the right to adjust the value of your account based on current market conditions. This adjustment is most often applied to distributions, partial or complete withdrawals, and exchanges to other accounts.

The most common adjustments are: cap, fee, participation rate or a combination of the three. Other adjustments are less common. In keeping with the preceding example and allowing for an 8% cap as the adjustment the policyholder would not receive the 16.07% point to point gain but rather 8% as an interest credit.

Should provide examples for: P2P with Participation Rate Monthly Averaging with Cap Monthly Averaging with Fee

Should also link to the Withdrawal Benefits provided in variable annuities and indexed annuties at this point. These concepts were added because of the risk associated with the accumulation in both variable annuities and indexed annuities.

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