What Is An Equity-indexed Annuity?

By Author: Ryan O'Donnell
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The Securities Exchange Commission (SEC) defines an annuity as a contract between you and your insurance company. Essentially, you pay into the contract, either in a lump sum or over time, and the contract makes periodic payments with interest at the end of the term. Terms can vary significantly, and cancelling early can have serious consequences.

Typically, a longer term contract will have more time to break even and make bigger periodic payments at the end of the term. Due to the complex equations for calculating interest earned, it is always best to clarify each term of the contract before you commit to an investment.

How Equity Based Annuities Work

Equity indexed annuities are linked to an equity index, typically the S-P 500, though other indexes may be used. Linking to an equity index allows the annuity to accumulate interest at varying rates based on the change in the S-P 500, rather than on a restricted contract-based rate which may or may not remain favorable to your annuity.

There is no need to worry that the index-based interest calculation will be unfavorable, however. Each annuity ...
... contract states a minimum interest rate so your interest will never fall below that set level. In other words, it is hard to lose with an equity indexed annuity.

Features to Look for in an Equity Indexed Annuity

There are several features of annuities which combine to make them a stronger investment. First, averaging is a protective measure if you initially buy into an annuity at a high point, or if there are severe changes in the linked index.

Second, the participation rate of the annuity is important for you to know. A high participation rate is often offset by averaging but a low participation rate may be offset by using the annual reset indexing method (explained below).

Third, caps are often put in place which limit the actual amount of interest you can earn annually but floor limits may also be in place to protect you from losses. Some equity indexed annuities will use a zero percent floor, meaning that even if the linked index loses value over the term, you will not go into the red with your annuity.

Common Indexing Methods for Equity Indexed Annuities

There are three basic types of indexing methods which may be applied to your annuity contract. Ask your financial advisor which of these methods (or which combination) is being used for your specific annuity.

Annual reset method: The annual reset method simply means that the index rate is determined each year on a specified date. The value at the beginning of the year is compared with the value at the end of the year, and interest is added based upon these numbers. An annually reset equity annuity is reviewed each year for the length of the contract. It is possible that annual reset annuities will credit more interest than those valued by other methods; however, caps are often put into place which may limit the actual amount of interest you will earn.

High water mark method: The high water mark method looks at the annuity's value at various points throughout the term (usually annually) and calculates interest on the difference between the highest value and the starting value. The interest is added to the equity indexed annuity at the end of the term. If the high water mark occurs at the beginning or middle of the term, interest credited will be higher; however, if you surrender the annuity before the end of the term, you may lose index linked interest.

Point to point method: Similar to the high water mark method, the point to point method looks at the difference between the value at the end of the term and at the start of the term, making for a somewhat more straightforward method. Interest is then added to the annuity at the end of the term. Point to point valued annuities may have higher participation rates which is an advantage overall; however, if you surrender the annuity before the end of the term, you may lose index linked interest.

Risk Factors and Equity Indexed Annuities

Equity indexed annuities are considered a safe way to grow your money, if you do not try to cancel the contract early. If the stock index rises, you gain interest up to the cap. If the stock index falls, you are protected by floors.

Always talk to a qualified financial advisor who will help you make decisions which are right for you.
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