An equity indexed annuity is an investment made through a contract with an insurance company which has variable and fixed annuities. It is a suitable retirement plan. When you invest in equity indexed annuities, you enjoy less risk than a variable annuity but less potential return.
Additionally, you enjoy higher potential return but more risk than a fixed annuity. A characteristic feature of the annuity is the two types of interest rates; an interest rate connected to a market index and a guaranteed interest rate.
The contract specifies whether you should pay the premium in a lump sum or whether to pay it periodically. After you make the payments, there is a waiting period before you start to receive periodic payments. The waiting period is called the accumulation period.
The participation rate is the extent to which an annuity owner takes part in the market gain.
Let us take an example where the participation rate is 75% and the index earns a 20% profit. In this case, you will earn 15% profit as a result of 75% participation rate. The advantage of this is that it protects you from downside risk. It means that you are protected from losses.
In the worst case scenario, you are entitled to at least break even every year on your premium contributions.
Advantages of Equity-indexed Annuity
- You enjoy higher returns than you would get from a fixed annuity.
- You are protected from the risk of loss due to the guaranteed interest rate even during downside market moments.
Disadvantages of Equity-indexed Annuity
- High surrender fees. If you want to cancel your annuity, the insurance company charges you a high fee for it. After canceling an annuity, you can only access your money after paying the penalties.
- Complexity. The equity-indexed annuities are complex in nature. The way they operate makes it difficult for people to predict their profitability. The marketing pitch used for the annuities is at times deceiving for potential investors.
- Short-changed index return. The securities do not pay the whole amount as promised. The different calculation method used contributes to the difference.
Different Indexing Methods
Annual reset considers the gains in the index throughout the year. Any losses are disregarded. The method is suitable when the stock market is doing well.
Unfortunately, insurance companies use other features to limit the interest that you can get when using annual reset. They can combine it with participation rates and lower cap rates.
High Water Mark
This method looks at the highest index gain during the year then compares the increase in the index at the beginning of the computing year. You are likely to get more interest rate and to be more protected against declines in the index.
On the other side, if you cancel the annuity before the year ends, you lose your earnings for the year. You will lose your gains because the interest is credited at the end of the year. The method uses participation and lower cap rates to limit the interest rate.
Point to point
The insurance company compares the rate of the index by looking at two discrete times. Point to point yields a higher interest as it combines other features like the participation and higher cap rates. The two features lead to higher interest rates.
If you surrender the annuity before the year ends, then you stand to lose your interest as it is calculated at the end of the year. Using two discrete points to calculate the interest is very risky.
Let’s say the index does so well during the year but on the last day, it declines; your interest is affected negatively.