An equity index annuity in the United States is a type of tax-deferred annuity whose credited interest is linked to an equity index — typically the S&P 500 or international index. It guarantees a minimum interest rate (typically between 1% and 3%) if held to the end of the surrender term and protects against a loss of principal. An equity index annuity is a contract with an insurance or annuity company. The returns may be higher than fixed instruments such as CDs, money market accounts, and bonds but not as high as market returns. Equity Index Annuities are insured by the State Guarantee Fund which is similar to the insurance provided by the FDIC. The guarantees in the contract are backed by the relative strength of the insurer.
The contracts may be suitable for a portion of the asset portfolio for those who want to avoid risk and are in retirement or nearing retirement age. The objective of purchasing an equity index annuity is to realize greater gains than those provided by CDs, money markets or bonds, while still protecting principal. The long term ability of Equity Index Annuities to beat the returns of other fixed instruments is a matter of debate.
Indexed annuities represent about 30% of all fixed annuity sales in 2006 according to the Advantage Group (see www.indexannuity.org)
Equity Indexed Annuities may also be referred to as Fixed Indexed Annuities or simple indexed annuity. The mechanics of how Equity Index Annuities work are often complex and the returns can vary greatly depending on the month and year the annuity is purchased. Like many other types of annuities, equity-indexed annuities usually carry a surrender charge for early withdrawal. These "surrender periods" range between 3 and 16 years, typically about ten.
A Different way to Credit Interest
The indexed annuity is virtually identical to a fixed annuity except in the way interest in calculated. As an example consider a $100,000 fixed annuity that credits a 4% annual effect interest rate. The owner then receives an interest credit of $4000. However, in an equity indexed annuity the interest credit is linked to the equity markets. For example assume the index is the S&P 500 and a one year point-to-point method is used and that the annuity offers a 8% cap. The $100,000 annuity could credit anything between 0% and 8% based on the change in the S&P 500. The cap, 8% in this example, is determined by how much is afforded by budget which is usually at or near the 4% fixed rate. If fixed rates increase then it would be expected that the cap would increase as well.
This allows the owner the security of knowing that the $100,000 is safe but rather than receiving the sure 4% they can receive up to 8%. Historically since 1950, an 8% cap on the S&P 500 has resulted in an average interest credit of 5.2%, very similar to what is considered the "risk free rate of return" delivered by T-bills, 5.1% over a similar period. The return may also be adjusted by other factors such as the participation rate and market value adjustments to cover bring the cost of the option into the budget available.
This means the owner of the indexed annuity now has assumed more risk than a fixed annuity but less than being in the equity markets themselves. The result is that the expected yield (risk adjusted) for an indexed annuity is higher than a fixed annuity, CD, etc. However, the expected yield of being in the market is higher for several reasons.
The principal (in our example the $100,000) is at risk of loss when owning the index outright. It should be noted that Equity Index Annuity does not participate in dividends as owning the index outright would and similar there are no ongoing transaction expenses or fees. Interest is compounded as frequently as when interest is credited and this is almost always annually but contracts are available that credit interest over a 5 year term.
The taxation of the gains in an indexed annuity are identical to that of fixed annuities. Taxes are deferred until monies are received and then interest is withdrawn first and taxed as ordinary income.
Understanding Options
This way of linking to an equity index like the S&P 500 or Dow Jones is accomplished through an option, usually a call option. A call option is the right but not the obligation to purchase something at a future date for a specified price.
The naming conventions for options used by the insurance industry is different than that of Wall Street but the options are structurally identical. Here's a sample of options commonly seen in indexed annuities.
- Insurance vs. Wall Street
- Point-to-Point vs. European
- Monthly Average vs.Asian
- Monthly Point-to_Point vs. Cliquet
- Performance Triggered vs. Binary
The options in indexed annuities can usually be fit into the following taxonomy developed by the National Association of Fixed Annuities.
Term - the length of time before option matures, usually one year. Two, three, four, and ten are also prevalent in the market. Some longer term options are but have a "highwater" feature that allows interest to be credited more frequently. An example of this would be a ten year Monthly Average option that credits interest each year if there is a gain.
Index - the equity, stock, bond, or other index to which the interest credit is linked.
Gain Formula - the method used to determine the gain in the index. Point to point, monthly averaging, daily averaging are the most common methods of calculating the gain. For example of the S&P 500 index starts at 1120 and ends at 1300 then the point to point gain is 16.07%.
Adjustment Method - the way the option is limited in order to reduce the cost (and subsequent return) so that it becomes affordable. As an example the point to point option may cost 7% of the account value but will be "adjusted" to reduce the cost.
"Market Value Adjustment" - the company may reserve the right to adjust the value of your account based on current market conditions. This adjustment is most often applied to distributions, partial or complete withdrawals, and exchanges to other accounts.
The most common adjustments are: cap, fee, participation rate or a combination of the three. Other adjustments are less common. In keeping with the preceding example and allowing for an 8% cap as the adjustment the policyholder would not receive the 16.07% point to point gain but rather 8% as an interest credit.
Should provide examples for:
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