Investing in Equity-Indexed Annuities Explained

Equity-indexed annuities are perhaps some of the most complex investment vehicles in the market today. This is mostly due to the variety of permutations possible. Equity-indexed annuities vary in features as well as interest calculation and indexing methods. This makes it difficult to compare and evaluate equity-indexed annuities.

Equity-Indexed Annuity Contracts

Equity-indexed annuities are annuity contracts between investors and insurance companies. Under the terms of the contract, the investor agrees to purchase the equity-indexed annuity contract through a lump sum payment or through installment. This lump sum payment or recurring contributions make up the investor's investment.

In exchange for the investor's investment, the insurance company pays the investor interest. While most equity-indexed annuities carry a guarantee of a minimum rate of return, equity-indexed annuities' returns are not fixed but based on the performance of a target equity index (e.g. the S&P 500 Composite Stock Price Index). The particular equity index to be used is named and identified in the contract. The interest rate on the annuity account is also known as index-linked interest rate because it is computed based on the performance of a particular index.

Equity-indexed annuities, just like regular annuity contracts, have an accumulation phase where the investor continues to make contributions. During this phase, too, his investment sits in the account and earns interest at the rate specified in the contract.

After the accumulation phase has passed, equity-indexed annuities mature. At this point, the investor starts receiving annuity distributions (usually monthly). He may also choose to withdraw all the funds in his equity-indexed annuity at once.

Differentiating Equity-Indexed Annuities from Fixed Annuities

As their name suggest, fixed-rate annuities come with a fixed rate of interest. In other words, fixed-annuity account owners can expect a fixed rate of return on their investment.

Equity-indexed annuities, on the other hand, use a formula that integrates the changes of a target index's performance in the calculation of interest. However, equity-indexed annuities have a minimum returns guarantee that protects investors in case index performance falls below expectations.

Risks Involved when Investing in Equity-Indexed Annuities

As with any other investment, there are risks involved when investing in equity indexed annuities. One such risk is the inability to guarantee the full return of your investment. Some equity-indexed annuities guarantee the return of up to 90 percent of your investment, which means you can still lose 10 percent of your original investment.

Another risk is are the tax penalties, loss of index-linked interest and surrender charges involved should you cancel early or fail to hold the contract until maturity.

Equity-Indexed Annuity Terms and Features

The key to making money out of equity indexed annuities is learning how its different features affect your investment and using your understanding of these different features in comparing the probable returns of different equity-indexed annuity products.

1. Interest Rate Features

How insurance companies compute an annuity's rate of return affects how much you can earn from an equity-indexed annuity account. The following are the methods by which insurance companies can compute interest rates.

Spread: Some insurance companies compute interest by subtracting a spread or a margin from the target index's gains.

To illustrate, let's suppose that the target equity index gains 7% in a particular interval and your insurance company charges a 2% spread to cover administrative costs. In that interval, your equity-indexed annuity account will not be credited the full 7% gain of the target equity index. Instead, you will be credited only a 5% return, which is 7% actual gain minus the 2% spread.

Participation Rate: Some insurance companies use the participation rate to compute an equity-indexed fund's interest rate. The participation rate determines how much of the target index's gains will be credited to equity-indexed annuity accounts.

To illustrate, if an equity-indexed annuity account has a participation rate of 92%, this means that the account's interest rate would be 92% of the target index's gains. Thus, if the target index gains 7% in a particular interval, an equity-indexed annuity account based on this index will be credited only 92% of the 7% or 6.44%, instead of the full 7% index gain.

The interest rate calculation method is just one aspect of interest rate terms that you should consider when comparing equity-indexed annuity products. There are other interest rate features (specifically interest rate floors and caps) that you should check out when calculating potential gains from an equity-indexed annuity.

Floor on Equity Index-Linked Interest: This is the guaranteed minimum interest that the annuity will earn according to the contract. A floor of 0% means that even if the target index performs poorly (i.e. logs a loss instead of a gain), the insurance company will not charge you a negative rate of return. The equity-indexed annuity account, in this case, will not be credited returns but nor will it register a loss.

Interest Rate Caps: This refers to the maximum amount of interest that you can earn on a particular interval. If an insurance company provides for an interest rate cap on an equity-indexed annuity, the owner of that annuity account cannot earn interest greater than the interest rate cap.

Let's say, for instance, that your equity-indexed annuity has an interest rate cap of 8% and your account's interest rate is 92% of the target index's gains. It just so happened that for this interval, the index to which your account is linked registers an 11% gain. To calculate your interest earnings, you should get 92% of 11%. This yields an interest rate of 10.12%. However, since your account has an interest rate cap of 8%, your account will only be credited up to this maximum rate, and the insurance company keeps the excess.

2. Equity Indexed Annuities Indexing Methods

Indexing methods are basically the methods used to determine the amount of change in the target index. The method used in calculating this figure has a very big impact on how much or how little investors earn on their annuities.

Point-to-Point: The point-to-point indexing method uses the values of the index-linked interest rates from the beginning to the end of the contract's term. The benefit of this indexing method is the chance of getting a higher participation rate. The downside in this case is the fact that investors have to see their annuity to maturity before their index-linked interest could be credited.

Annual Reset: The annual reset or ratchet indexing method takes into account the increase in index value from the beginning to the end of the year. The index's performance from the start of the year is compared to the index's performance at the end of the year. The difference between these two figures becomes the index gains used in calculating equity-indexed annuities' interest rates.

The advantage of having this indexing method in your equity indexed annuity is that it essentially locks in your interest earnings every year. This protects your returns from any future declines in the target index's performance. This indexing method, however, is commonly used in conjunction with measures to limit earnings such as low participation rates and low interest rate caps.

High Water Mark: The high water mark method uses as a starting value the value of the target index at contract start. The insurance company then logs the values of the index at specific periods throughout the term of the annuity contract (say, every year, at the anniversary of the annuity contract). Upon contract maturation, the starting index value is subtracted from the highest index value ever registered. This becomes the index performance gain used as basis for calculating the equity-indexed annuity account's interest earnings.

Important notes: You should never make a decision based on a single feature. You should always compute potential earnings based on a combination of the important interest-rate features and indexing methods. For instance, a high participation rate may actually be countered by a low interest rate cap. A favorable indexing method, on the other hand, may be countered by a low participation rate or low interest rate floor. A high floor may also be countered by a low participation rate, a low interest rate cap, or a less than favorable indexing method.

Insurance companies may also compensate for undesirable interest rate terms and indexing methods by including positive features like partial withdrawal options and annual crediting of returns.

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