Understanding Indexed Annuities
There are two primary types of annuities: fixed and variable. In a fixed annuity, the insurance company guarantees to credit your account with a minimum amount of interest during the accumulation, or earnings, phase of the contract. The company also guarantees to make periodic payments to you during the payout phase under the payment option you select. There are numerous payout options for you to choose from, such as fixed payments to you for life, payments to you for only a specified period of time, or payments over the combined lives of you and your spouse. Fixed annuities are not securities, and are not regulated by the SEC. Premiums paid in are placed in the insurance company’s general account, which is a commingled fund used to back all guarantees of the insurance company under all insurance and annuity contracts.
In a Variable Annuity, you have control over the investments during the accumulation phase. You, as contract owner, and not the insurance company, may choose to have your premiums invested in a number of investment options, usually mutual funds. The periodic payments you eventually receive will be fixed, but the calculation of the payments will be dependent upon the investment performance of the funds you selected during the accumulation phase. Since contract values are totally dependent upon the investment return of selected mutual funds, variable annuities are considered securities and, therefore, regulated by the SEC.
Equity Indexed Annuities – Overview
An equity indexed annuities combines certain aspects of fixed annuities and variable annuities. During the accumulation phase, you receive credited interest based on the performance of the mutual funds selected. The rate of return paid is linked to a financial market index, usually the Standard & Poor’s 500 Composite Stock Price Index (S&P 500). If the index goes up, your account is paid a portion of the gains. If the index goes down, you are protected from suffering significant losses since the principle is guaranteed. The insurance company also promises to credit your account with a minimum guaranteed interest return. During the payout phase, the insurance company will make guaranteed periodic payments under the payout option you select at that time.
Equity indexed annuities are considered to be fixed annuities and are not subject to SEC regulations. This is due to the crediting of a minimum guaranteed interest rate and guarantee of principle by the insurance company.
Contract Details Affecting Earnings
Several factors affect the amount of interest credited to the account each year. Each of these factors needs to be compared and analyzed when shopping for an equity index annuity.
Participation rate – this rate calculates the amount of increase in the linked index that will be paid. If the participation rate is 80%, and the S&P 500 rises 4%, the annuity contract would be credited with 3.2% (.80 times 4%).
Methods of Crediting the Participation Rate
- The Annual Reset or Rachet – This method calculates the annual percentage change in the linked index from the start of the contract year to the end of the contract year. This method locks in your gains each year, which can be beneficial if rates drop at the end of the year.
- The High Water Mark – This method identifies the highest level of the linked index during the year and uses this as the comparison point at the start of the next year. More interest may be credited using this method than other indexing methods, but interest is not credited until the end of the term.
- The Point-to-Point – This method calculates the change in the linked index between account values at the beginning and end of the year. This method may produce more interest if the interest and participation rates are relatively high. However, the high point during the year may end up being lower than other points during the term of the contract.
- Interest Rate Cap – Some equity indexed annuity contracts have a maximum rate that will be credited over a certain period of time. If the maximum interest rate is 8%, and the S&P 500 rises 20%, your contract will be credited with only 8%. On the other hand, some upside potential with no downside risk can be quite beneficial depending upon your investment objectives and risk tolerance level.
Administrative and Management Fees
Some insurance companies will charge administrative and management fees, as percentage of account value. These fees will be deducted from your earnings under the contract. Other companies may have no administrative fees, but higher management fees. It is important to identify what fees are charged and how they will be calculated because these fees are not always easy to spot in the contract.
Benefits of an Equity Indexed Annuity
These annuities are well suited for conservative investors who need some exposure to equity investments, but cannot afford a severe dip in their retirement assets. Older investors nearing their retirement age or high income investors who have surpassed the maximum limits under their retirement plans may be excellent candidates for an equity index annuity.
No Two Contracts are the Same
It would be easy to compare contracts if all insurance companies were mandated to use the same provisions, and only the percentages or numbers could change. Unfortunately, this dream does not exist since the equity index contracts cannot be bought and sold like a share of common stock. The characteristics and factors noted above are the provisions found in all equity index contracts. However, the provisions might be called by different names and the factors may vary in how the exactly work. Accordingly, you need to thoroughly understand the provisions of each contact and ask many questions of the selling insurance agent. This is a long term investment; one affecting your entire retired life. A bit of reading and questioning now will prevent unexpected results later on.
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