Equity index annuities are annuities that earn interest based on the performance of another financial instrument. For example, the annuity can be linked to a stock or an equity index. The most commonly used index for this type of annuity is the S&P 500.
With an equity index annuity, interest is credited to the annuity based on a formula that is linked to the performance of the equity index. The interest rate of the annuity does not need to match the index performance exactly. It will just be linked to it. In addition, an equity index annuity will pay investors a minimum interest rate in case the index performance for the accumulation period is not above a certain threshold.
The exact performance of an equity index annuity is based on the indexing method and the participation rate that is used. The indexing method is how a change in the index is measured. The most common indexing methods are annual reset (or ratcheting), high-water mark, and point-to-point.
The participation rate is used in the formula to calculate the interest paid for the annuity. It is a metric that decides how closely the annuity will track the performance of the index. For example, if the change in the index is calculated to be 5% and the participation rate is 80%, the interested rate for the annuity will be 4% (5% x 80%). The participation rate can vary over the life of the annuity depending on the terms of the contract.
Some equity index annuities will also have a cap or a floor specified in the contract. The cap is the upper limit that the interest rate can be. Likewise, the floor is the minimum interest rate that the annuity will earn.
One of the advantages of equity index annuities is that they are low risk. They also offer good growth based on the market. One of the other advantages is that the investor does not have to manage their premiums. Once the contract is initiated, it is linked to the performance of the index for the term of the contract.
A disadvantage for equity index annuities is that the annuity contract itself can be complicated. With all of the metrics discussed above – participation rate, indexing method, etc. – some pitfalls do exist for the new investor. However, if the investor pays close attention to the detail of the contract, an equity index annuity can be the best product for them.
Equity index annuities are well-suited for investors who have an investment horizon of five or more years. This type of annuity is also suitable for retirement planning.
In summary, equity index annuities are annuities that earn interest based on the performance of an equity index, such as the S&P 500. The contracts for these types of annuities can be complicated to a new investor. However, if the investor pays attention to the detail of the contract, equity index annuities can be a good retirement investment vehicle, especially if the investor has an investment horizon of five years or more.
For more information from Steven on how to invest in annuities and common investment mistakes, visit his
Annuities Investment Guide. To learn more about the retirement annuities, visit the
Immediate Annuity and
Deferred Annuity Guides.
