Fixed annuities assure your income based on current interest rates which are rather low. You may not want to lock yourself into 3.5% for several years. Going through a long retirement horizon, you may want to think about relying on the markets to improve you annuity income. Equity-indexed annuities offers that possibility but you must understand how they work.
Equity-indexed annuities combine top features of traditional insurance annuities (assured minimum interest and guarantee of principal) and classic securities or variable annuities (where the return is related to equity markets).
Here's how equity indexed annuities work:
In the accumulation period - whenever you make either a lump sum payment or perhaps a series of payments - the insurance company credits your annuity a return based on changes in a common equity index. The S&P 500 is a typical index (the S&P 500 is an unmanaged index associated with 500 of the largest cap US stocks and cannot always be invested in directly).
The insurance company normally guarantees a minimum return such as 2.5% annually, even if the stock market remains flat for the entire length of your equity indexed annuity contract. Surrender charges can last for many years (contract terms can range from 5 to 20 years) and it is possible to lose cash if the investor cancels the equity indexed annuity policy prior to the end of the term. If there is no increase in the main index during the designated term, policy holders receive only the minimum guaranteed annuity rate minus expenses and distributions.
After the accumulations phase (e.g. 5 to 20 years, depending on the contract you select), the equity indexed annuity company will make regular annuity payments to you unless you take your contract benefit as a lump sum. Most people do opt for some type of payment plan so as to spread the annuity tax on their gains over several years.
Understanding how your interest rate used in your contract is related to the equity index determines what edge you really get over a fixed annuity. Let's take a look at how interest is calculated and added to equity indexed annuities.
Features of Equity Indexed Annuities
The Participation Rate determines how much of the index's increase will be used to compute the index-linked interest rate. For instance, if the participation rate is 75% and the index (i.e the stock market) increases 10% for the year, the return deposited into your annuity would be 7.5% (10% x 75%).
Interest Rate Caps: Some equity-indexed annuities impose a maximum rate of interest that you can earn. If the policy has an upper limit, say 7%, and the index linked to the annuity obtained 7.5%, only 7% would be paid to your account.
The Margin, Distribution or Administrative Fee: The particular index-linked interest for some annuities is determined by subtracting a 'fee' portion from any gain in the index. This kind of fee is sometimes called the 'margin,' 'spread,' or even 'administrative fee.' An annuity with a 'spread' associated with 3%, will credit a return of just 7% if the index gained 10% (i.e. 7% = 10% - 3% fee).
The method associated with computing the index change will influence your return too. Several indexing methods are:
Annual Reset to zero (or Ratchet). This method credits index-linked interest determined by any increase in index value in during a single 12 month period. So if you have an increase in your account in year one, a decline in the index in year two will not erase any of that gain from year one. This is a beneficial feature that most annuities companies no longer offer or if offered, is offset by a feature that benefits the insurance company.
Point-to-Point. This technique credits index-linked interest based on any appreciation in index value from the beginning to the conclusion of the contract's term (e.g. 10 years). That means that if your account gains 10% in the first year but loses 4% in the second year, you will have a net gain on your contract of 6% at the end of year two. Note that a contract having the annual reset feature as described in the previous paragraph would have a 10% gain.
Equity indexed annuities have some complexity ot their design so having an independent annuity agent review several contracts with you is valuable.