Equity Indexed Annuity – The New “Cutting Edge” Option for Retirees

Entering into the new millennium, the financial landscape for retirees changed dramatically. Today, with soaring unemployment rates and an unstable economy recovering from two major crashes, the focus has shifted away from amassing huge wealth. In the current economic scenario, saving and investing enough to have a retirement income that even covers the costs of living is an unending struggle.

Pre-2000, financial experts and advisors would suggest a safe withdrawal limit of about 4%, but now they recommend about half that. The new equity-indexed annuity models are designed to overcome the limitations of traditional retirement income sources and are gaining immense popularity, even over variable annuities.

What is an Equity Indexed Annuity?

Like traditional annuities, equity-indexed annuities can be immediate or deferred fixed annuities regulated as insurance products and not as investments. The account value used for calculating the interest you earn is based on a stock or an equity index, most often the Standard & Poor's 500 Composite Stock Price Index (S&P 500). They use a low-risk approach, where you forgo huge returns if the market does well, but you get the safety-net of a guaranteed minimum growth and still benefit somewhat if there's an economic boom.

Your investments are not exposed to daily market fluctuations, since the interest is based on how the market performs over a period of time. Equity-indexed annuities shouldn't be confused with owning stocks, and the contract can include features that offer limited risks against markets performing poorly, as well as caps on the maximum interest you can earn if they grow.

How is It Different from Other Fixed Annuities?

Traditional fixed annuities have either a fixed rate of interest agreed upon in the contract, or they credit the interest at rates which can vary from time to time. Equity-indexed annuities have a minimum interest rate that you will definitely receive and additional interest that depends on the performance of the index it is linked to.

At the end of each term, the insurance company adjusts the value of the annuity according to the performance of the index. The value of the annuity also has a minimum guarantee, which is available for withdrawals, death benefits and some annuity income payments too.

Common Features of Equity Indexed Annuity Contracts

Understanding the features of contracts and how they affect you is crucial for choosing one that suits your requirements. New equity indexed annuity products are being developed with a host of features, but here are some of the most common features you'll find and how they work:

Participation Rate - Along with the indexing method, the participation rate has the greatest effect on the index-based interest. The participation rate is used to calculate what percentage of the change in the index value will be used for calculating the index-based interest.

Basically, if your participation rate is 70%, and the calculated increase of the index is 10%, the interest will be calculated as 70% of the 10% increase, which is 7%.

Indexing Method - The indexing method is basically the method used to calculate the change in the index and the interest you'll earn. There are three ways of interpreting the performance, each with its own tradeoffs.

• Annual Reset - The index-linked interest is calculated based on the value of the index at the beginning and end of each year. If it has gained, the interest is credited annually and the value is reset. The value at the end of the year is used to calculate the performance of the next year, so future decreases will not affect any interest you've already earned.
  
  The advantage of this method is your investments are safer if the market fluctuates often, but the participation rate may change annually and it's usually lower. Additionally, most models using the annual reset method use averaging or a cap to limit the interest you can earn.
• High-Water Mark - The high-water mark indexing method calculates and credits the interest once, at the end of the term of the annuity. The performance of the index is recorded at intervals, usually annually, and the interest is calculated using the difference between the highest point recorded and the value at the start of the term.
  
  While you may get better returns if the index peaked during one of the points and then dropped off again, the trade-off is the longer period before you receive returns. As with the annual reset method, the participation rate can be lower, with a limited maximum return.
• Point-to-Point - The index-based interest in the point-to-point method is calculated on the difference in the value of the index at the end of the term and the beginning. Since the interest is only calculated at the end of the entire term, products that use the point-to-point indexing method generally allow for much higher participation rates. However, you may not get any interest-linked interest for the entire term.

Cap and Floor on Index-Linked Interest - All fixed annuities will have a minimum guaranteed value, but the index-linked interest may have a cap rate which limits the maximum additional interest you earn.

For example, if the increase of the index is calculates as 10%, but your cap rate is 5%, you will only earn 5% index-linked interest. Similarly, if there is a floor rate, it limits the interest from falling below the specified rate. The most common floor rate is 0%, so even if the index drops in value, you won't lose any money.

Averaging - Some annuities may use an average of the performance of an index, as opposed to calculating the performance based on the actual value on specified dates. The averaging can be done at the beginning, end or during the entire term of the annuity.

Administrative Fee - In some annuities, along with or in place of a participation rate, there may be an administrative fee or “margin”. This is a specific percentage that gets subtracted from the calculated change of the index value, before the index-based interest is calculated. If your administrative fee is 2%, and the calculated increase of the index is 7%, the index-linked interest will be calculated on 7%-2%, i.e. 5%.

Index-Linked Interest Compounding - Another feature to look for in your contract is interest compounding of the index-linked interest. While the interest your premium earns will almost always be compounded for the next term, some annuities offer simple interest on the index-linked interest you earn in the term. The amount is added to your premium, but will not be compounded for the next term.

If your contract has index-linked interest compounding, the earnings from one term will be utilized in the next term for calculating interest.

Vesting - Some annuities will not credit your index-linked interest, or part of it if you withdraw your money before the term has ended. The vested percentage is the amount you will receive if you take all the money out of the annuity at a given time. It generally increases as the term progresses and by the end of the term, it is 100%, meaning you'll get the entire amount.

Benefits Linked to Index-Linked Annuities

Annuity Income Payments - You can use the value the annuity has built up to provide income payments for the payout period of deferred annuities. These payments are usually made on a monthly basis, but you can choose to receive them at a frequency that suits you. The amount you receive depends on the value the annuities have gained and the benefit rate applied when the payments start.

The benefit rate depends on a variety of criteria, including your age, sex and the type of annuity. This rate is used to calculate the amount of the income payments you'll receive for every $1,000 your annuity has accumulated. Depending on the terms of your contract, the payments can continue for a set time period, as long as you live, or to you or your spouse for life.

Tax Deferral - The interest your annuity accumulates is not subject to federal income tax until you withdraw it. Once you start withdrawing it, the amount may be treated as taxable income, and it could attract an early-withdrawal tax penalty if you make withdrawals before you're 59 ½ years old.

This offers significant advantages, because you may be in a lower tax bracket when you start withdrawing the accumulated interest. The amount you would otherwise pay as taxes will also keep earning interest during that time.

Death Benefit - There are a variety of death benefits linked to annuities, which are paid to your estate in case of your demise. Most commonly, they carry a death benefit which is equal to the guaranteed minimum value or determined by an index-linked formula. Different annuities offer different terms, so you should check the death benefits before you pick one.

Is Equity-Indexed Annuity Right for You?

Now, you may be wondering if an equity-indexed annuity is the right choice for you. Since your needs and expectations are unique, you should take a few things into consideration. As with any other personal finance product, there are some risks and advantages that you should weigh carefully, looking at features like:

• Term - Annuities can be immediate and deferred. You should consider how long you can afford to leave the money in an annuity. Early withdrawals can attract penalties and reduced interest.
• Payouts - How do you plan on using the money from the annuity? Will periodic payouts be sufficient or would lump-sum returns suit you better? These are some questions that will determine which is the right choice for your needs.
• Returns - Equity-indexed annuities may be a safer bet for a guaranteed return without risking your primary investment very much. Variable annuities, on the other hand, have greater risks but can also gain much higher returns.

Which Equity-Indexed Annuity is Best for You?

Just like any other insurance product, choosing an equity-indexed annuity is a matter of comparing the features and benefits of various products and finding one that suits your needs the best. Keep in mind that predicting the future behavior of a market index is difficult and even experts are often wrong.

A good investment begins with a thorough understanding of the features of the contract and any trade-offs. Familiarize yourself with the terms of the contract and if you're unsure about any of them, ask the agent or the company for more details or explanations. Opting for the safer route will definitely keep your investments protected, but the reduced risk comes at the cost of reduced income opportunities.

With the fluctuating economy and increased cost of living make equity-indexed annuities a lucrative option, but the ultimate decision between playing it safe and taking a make-it-or-break-it risk is one you shouldn't take lightly. Indexes like the S&P 500 are gaining rapidly and they're at their highest yet, but that's no guarantee of the future!