Equity Index Annuities
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What are Equity-Indexed Annuities?
- How Are They Different From Other Fixed Annuities?
- What Are Some of the Contract Features?
- How Do the Common Indexing Methods Differ
It is important to note that even though it is called an Annuity, you will get a Lump Sum back at the end of the term unless you Annuitize. To Annuitize means to turn in the contract for a Lifetime Stream of Income (other income streams are also available).
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What Is An Equity-Indexed Annuity:
It is a fixed annuity, either immediate or deferred, that earns interest or provides benefits that are linked to an external equity reference or an equity index. The value of the index might be tied to a stock or other equity index. One of the most commonly used indices is Standard & Poor's 500 Composite Stock Price Index, which is an equity index. The value of any index varies from day to day and is not predictable.
When you buy an equity-indexed annuity, you own an insurance contract. You are not buying shares of any stock or index.
While immediate equity-indexed annuities may be available, this guide will focus on deferred equity-indexed annuities.
How Are They Different From Other Fixed Annuities?
It is different from other fixed annuities because of the way it credits interest to your annuity's value. Some fixed annuities only credit interest calculated at a rate set in the contract. Other fixed annuities also credit interest at rates set from time to time by the insurance company. Equity-indexed annuities credit interest using a formula based on change in the index to which the annuity is linked. The formula decides how the additional interest, if any, is calculated and credited. How much additional interest you get and when you get it depends on the features of your particular annuity.
The annuity, like other fixed annuities, also promises to pay a minimum interest rate. The rate that will be applied will not be less than this minimum guaranteed rate even if the index-linked interest rate is lower. The value of your annuity also will not drop below a guaranteed minimum.
What Are Some of the Contract Features?
Two features that have the greatest effect on the amount of additional interest that may be credited to an equity-indexed annuity are the indexing method and the participation rate. It is important to understand the features and how they work together. The following describes some other equity-indexed annuity features that affect the index-linked formula.
Term
The index term is the period over which index-linked interest is calculated; the interest is credited to your annuity at the end of the term. Terms are generally from one to ten years, with six or seven years being most common.
Participation Rate
This feature decides how much of the increase in the index will be used to calculate index-linked interest. For example, if the calculated change in the index is 8% and the participation rate is 65%, the index-linked interest rate for your annuity will be 5.2% (8% x 65%). A Company may set a different participation rate for newly issued annuities as often as each day. The company usually guarantees the participation rate for a specific period (from one year to entire term). When that period is over, the company sets a new participation rate for the next period.
Indexing Methods
The indexing method means the approach used to measure the amount of change, if any, in the index. Some of the most common indexing methods, which are explained more full later on, include annual reset, high-water mark and point-to-point.
Cap Rate
Some annuities may put an upper limit, or cap, on the index-linked interest rate. This is the maximum rate of interest the annuity will earn. Many annuities do not include this feature or restriction.
Averaging
In some annuities, the average of an index's value is used rather than the actual value of the index on a specified date. The index averaging may occur at the beginning, the end, or throughout the entire term of the annuity.
Floor on Equity Index-linked Interest
The floor is the minimum index-linked interest rate you will earn. The most common floor is 3%. A 3% floor assures that even if the index decreased in value, the interest that you earn will be a minimum of 3% and not negative.
Vesting
Some annuities credit none of the index-linked interest or only part of it, if you take out all your money before the end of the term. The percentage that is vested, or credited, generally increases as the term comes closer to its end and is always 100% at the end of the term.
How Do the Common Indexing Methods Differ?
Annual Reset
Index-linked interest, if any, is determined each year by comparing the index value at the end of the contract year with the index value at the start of the contract year. Interest is added to your annuity each year during the term.
High-Water Mark
The index-linked interest, if any, is decided by looking at the index value at various points during the term, usually the annual anniversaries of the date you bought the annuity. The interest is based on the difference between the highest index value and the index value at the start of the term. Interest is added to your annuity at the end of the term.
Point-to-Point
The index linked interest, if any, is based on the difference between the index value at the end of the term and the index value at the start of the term. Interest is added to your annuity at the end of the term.