Equity-Indexed Annuity: How They Work and Their Limitations

Potential earnings are higher, but there are more risks and more fees

Fact checked by Timothy LiReviewed by Chip StapletonFact checked by Timothy LiReviewed by Chip Stapleton

An equity-indexed annuity is a type of fixed annuity that is distinguished by the interest yield return being partially based on an equities index, typically the S&P 500.

Equity-indexed annuities appeal to moderately conservative investors who like having some opportunity to earn a higher investment return than what’s available from traditional fixed-rate annuities, while still having some protection against downside risk. But they are complex and have some disadvantages to keep in mind if you are considering purchasing one.

Key Takeaways

• An equity-indexed annuity is a fixed annuity where the rate of interest is linked to the returns of a stock index, such as the S&P 500.
• Equity-indexed annuities may appeal to moderately conservative investors.
• They are complex and there are drawbacks, such as high fees and commissions.

How an Equity-Indexed Annuity Works

An annuity is essentially an investment contract with an insurance company, traditionally used for retirement purposes. The investor receives periodic payments from the insurance company as returns on the investment of premiums paid. There is an accumulation period when the premiums paid earn interest in accordance with the terms of the annuity contract, followed by a payout period.

In the case of equity-indexed annuities, also commonly referred to as indexed annuities, part of the interest rate earned is a guaranteed minimum, typically 1% to 3% paid on 90% of premiums paid. The other part is linked to the specified equities index.

Earnings from equity-indexed annuities are usually slightly higher than traditional fixed-rate annuities and lower than variable-rate annuities, but with better downside risk protection than variable annuities usually offer.

Special Considerations

A key feature of equity-indexed annuities is the participation rate, which basically limits the extent to which the annuity owner participates in market gains. If the annuity has an 80% participation rate, and the index to which it is linked shows a 15% profit, the annuity owner participates in 80% of that profit, realizing a 12% profit.

Important

Equity-indexed annuities are relatively complex investments, not appropriate for novice or unsophisticated investors.

In return for accepting limited profits, investors receive protection against downside risk, usually a guarantee of at least breaking even each year that interest is earned in terms of the equity index portion of earned interest. Some equity annuities also have an absolute cap on total interest that can be earned. Another aspect to consider is whether or not interest earned is compounded.

Indexed annuities use one of three formulas to determine the changes in the equity index level that interest payments are calculated from. The most common is the annual reset formula, which looks at index gains and ignores declines. This approach can be a substantial benefit during down years in the stock market.

A second formula, the point-to-point method, averages the index-linked return from the index gains at two separate points in time during the year.

The third option, the high-water mark, looks at the index values at each anniversary date of the annuity and selects the highest index value from those to then be averaged with whatever the index value was at the beginning of the payment term.

Advisor Insight

Scott Bishop, CPA, PFS, CFP®
STA Wealth Management LLC, Houston, Texas

An equity-indexed annuity is a fixed annuity where the rate of interest is linked to the returns of an index, such as the S&P 500. The rate of growth of the contract is typically set annually by the insurance company issuing and guaranteeing the contract.

There are pros and cons to these types of annuities, but underlying issues do have to be considered. First, they are complicated, as insurers use different methods to calculate the index return. Second, equity-indexed annuities don’t typically include reinvested dividends when calculating index returns, yet dividends have historically accounted for nearly 40% of the market’s total return. Finally, these annuities often carry steep surrender charges. At the end of the day, it’s the insurance company and underlying guarantees that are important.

What Is an Equity-Indexed Annuity?

An equity-indexed annuity is a long-term financial product offered by an insurance company. It guarantees a minimum return plus more returns on top of that, based on a variable rate that is linked to a certain index, such as the S&P 500.

What Are the Disadvantages of an Equity-Indexed Annuity?

One disadvantage of equity-indexed annuities is high surrender charges. If the annuity owner decides to cancel the annuity and access the funds early (that is, before the age of 59½), cancellation fees can run high, in addition to a 10% tax penalty. Historically, equity-indexed annuities have also been subject to high commission fees.

Are Equity-Indexed Annuities Risky?

Equity-indexed annuities are moderately risky. They are more conservative than variable annuities—that is, there’s less potential for high returns, and less potential downside. However, they’re riskier than other fixed annuities.

The Bottom Line

Like any investment, it’s key to understand how equity-indexed annuities work, and the risks involved, before deciding to purchase one.

Equity-indexed annuities are complex and there are numerous factors that can significantly affect the investment’s potential profitability. Some analysts question whether these annuities can be considered a good investment at all.

Read the original article on Investopedia.