Equity-Indexed Annuities - Best of Both Worlds?
Jan 24, 2008 Write an essay on this topic.
The Bottom Line As with all investment options, safety and security come at a price. Just make sure you're not paying to high a premium for your peace of mind.
Equity-indexed annuities seem to offer the best of both worlds; they get you stock market gains, but with a safety net against the downside risk that is inherent in an index fund or an exchange-traded fund. Sounds like a great plan especially in todays slumping housing market and the uncertainty inherent in a Bear Market. However, there are major drawbacks to Equity-Indexed Annuities that need to be well understood before you dive in.
An annuity is a contract between you and an insurance company. You deposit money either lump-sum or scheduled payments and the insurance company will hold those payments until such time as you elect to annuitize the balance. At that time the insurance company will return your payments at an agreed upon rate based on a pre-set schedule of time. With a fixed annuity, the insurance company guarantees the rate of return; with a variable annuity, the rate of return varies with the performance of the investment option you choose; you could earn a higher rate of return than a fixed annuity, but you could also lose money.
Equity-indexed annuities are a mix of the fixed and variable annuities. They offer more upside, but also more risk, than a fixed annuity, but they have less risk, and also less upside, than a variable annuity.
The largest issue that most people have with Equity-Indexed Annuities is that it can be almost impossible to understand how much of an index's return you are giving up in exchange for the promise that you won't lose your money. The methods used to calculate your return differ from one company to the next, making it tough to compare apples to apples. To make matters worse, the method for calculating returns may switch from year to year within the same policy, depending on the performance of the stock market.
Some of the features used to limit both the downside and upside of returns on equity indexed annuities include:
Interest rate caps: This is the maximum rate you will earn, and it is usually the average of the index's performance over the year. (The way the average is calculated varies from one provider to another.) No matter how much the index actually returns, this average is all you get. In other words, if the contract has a 6% cap but the index average performance over the year is 10%, the amount credited to your investment will be 6%. Because interest rate caps can be reset each year depending on the performance of the market, there are also guaranteed caps.
Guaranteed caps: A guarantee cap will guarantee that the interest rate cap will not go below a given percentage. For instance, if a product has a guarantee cap of 5%, this means the interest rate cap cannot be reset below this amount. (But you can still earn less than 5% if the market's rate of return falls below that level.)
Participation rate: This is the percentage of an index's performance that will be credited to your account. If the participation rate is 80% and the index returns 9%, your account will be credited with 80% of 9%, or 7.2%. The participation rate may also be reset year over year and can vary from 45% to 100%.
Margin: Also known as a spread, this is the percentage of an index's return that will be subtracted before crediting your account. For instance, if the spread is 3% and the index returns 8%, the amount credited to your account will be 5%. Again, this amount can be reset year over year and can vary from zero to 100%.
Equity indexed annuities can also feature one-time premium "bonuses." This is a fixed percentage of the premium, usually for a single premium amount paid in the first year of the policy. Obviously, it's an incentive to get investors to put as much money up front as possible. Some insurers offer premium bonuses as high as 12%. So if you decide to invest $100,000 and transfer this amount as a one-time lump, the insurer will credit you $12,000, leaving you with $112,000.
Some equity indexed annuities also feature floors, or guaranteed minimum returns, which average around 3%.
Contract features can change as often as twice a year, so it's important to understand the terms. Equity indexed annuities are designed to adjust their terms according to the performance of the market. Contracts with higher guaranteed minimums may perform better in a down market, while some products that either have no cap or a higher participation rate may perform better if the market does well.
Complex terms aren't the only drawbacks to equity-indexed annuities, however. Close to half of these products credit policy-holders with simple interest, not compound interest. Compounding, or adding interest to the principal, is the single most powerful way to grow your investment. If you only receive interest each year on the basis of your original principal, your cumulative returns will be much lower.
Equity indexed annuities also apply big fees to early withdrawals (those made before age 59 ½). These can be big enough to eat into your principal investment. Some insurers will charge as much as 20%, although the amount usually declines each year until maturity. When you make an early withdrawal, you also lose the initial bonus premium and in some cases the interest on your investment as well.
Investors who want to earn at least some of the stock market's returns might be better off constructing their own portfolio of Treasury bonds and mutual funds. Treasury bonds provide stability with a guaranteed rate of return while mutual funds can provide an opportunity for compound interest growth without all the commission and surrender charges.
Remember, any insurance product is a contract between you and an insurance company. So it's important to make sure the insurer has a strong financial rating. The assets in equity-indexed annuities are held in the insurance company's general accounts. This means that if the insurance company fails, you could loose part or all of your investment.
Three key points to take with you:
1. In a down market look for the highest guaranteed interest rates.
2. In a strong market look for companies that offer no cap and the highest participation rates.
3. No matter what, always look for the policy offering compound interest versus simple interest.
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