An Insight into Equity Indexed Annuities

A contract between an investor and an insurance company is called an annuity. A series of payments or a lump-sum payment is made by the investor under an annuity. Fixed and variable are the two types of annuities. The investor is guaranteed by the insurance company that he will earn a minimum rate of interest during the growing time of the account, in a fixed annuity.

Equity-indexed annuity is a type of fixed annuity which combines the features of traditional securities (they are return linked to equity markets) and of traditional insurance products (they guaranteed minimum return). An equity-indexed annuity may or may not be a security. It depends on the mix of features. The typical type of equity-indexed annuity is not registered yet with the SEC.

A special type of contract between an insurance company and an investor is an equity-indexed annuity. During the accumulation period, when a series of payments are made or a lump sum payment is made the investor is credited with a return that is based on changes in an equity index by the insurance company. For example, The Stand & Poor’s 500 Composite Stock Price Index. Typically, a minimum amount of return is guaranteed by the insurance company. The insurance company will make a lump sum payment or periodic payments after the accumulation period under the terms of the contract.

If the guarantee is based on an amount which is less than the full amount of the purchase payments money can still be lost even if it is with a guarantee. In many cases it, it takes many years for an equity-index annuity’s minimum guarantee to “break even.” If an annuity is cancelled early such as tax penalties or surrender charges, some investments can be lost. In some cases, the investor may not be credited with index-linked interest by the insurance companies if the contract is not held until maturity.

There are several features in Equity-indexed annuities that can affect the return. Understanding fully how an equity-indexed annuity computes its index-linked interest rate before purchasing them is very important. An investor may be credited by the insurance company with a lower return than the actual index’s gain.

Some common features used for computing an equity-indexed annuity’s interest rate are:

Participation Rates

How much of the index’s increase will be used to calculate the index-linked interest rate is what is determined by the Participation Rates.

Interest Rate Caps

A maximum rate of interest is set by some equity-indexed annuities that the equity-indexed annuity can earn. If a contract has an upper limit, or cap, of 7% and the index which is linked to the annuity gained is 7.2%, only 7% would then be credited to the annuity.

Margin/Spread/Administrative Fee

By subtracting a percentage from any gain in the index, the index-linked interest is determined for some annuities. This fee is sometimes called the “margin,” “administrative fee,” or the “spread.”

Indexing method is another feature that can have a dramatic impact on an equity-indexed annuity’s return. Indexing method is how to determine the amount of change in the relevant index. Some common indexing methods are:

Annual Reset (or Ratchet)

Index-linked interest which is based on any increase in index value from the beginning to the end of the year is credited in this method.

Point-to-Point

Index-linked interest which is based on any increase in index value from the beginning to the end of the contract’s term is credited in this method.

High Water Mark

Index-linked interest which is based on any increase in index value from the index level which is at the beginning of the contract’s term to the highest index value at various points during the contract’s term is credited in this method.

These and many other features may be included in an equity-indexed annuity. It is important for investors to understand how the features work and what impact, along with other features; it may have on the annuity’s potential return before purchasing an equity-indexed annuity.