An equity index annuity is a type of annuity linked to the performance of a market index, like the S&P 500. Equity index annuities are unique because they allow annuity owners to participate in market returns of a chosen index, while guaranteeing against loss of principle.
Equity index annuities have similarities to both fixed and variable annuities. Like fixed annuities, equity index annuities are often invested with a single up-front payment. Like variable annuities, index annuity rates vary based on market performance. But unlike variable annuities, equity index annuity holders are typically covered against losses.
Equity index annuities have historically averaged 7-10% on up years and 1-3% on down years. For this reason, index annuities provide investment security with a potential higher upside if the market performs well. This is not to say index annuities do not come with risk. In prolonged periods of down markets, equity index annuities can under-perform CDs and may not even outpace inflation.
If you purchase a equity index annuity and pass away while it is in force, and you have named a beneficiary (such as your spouse or child), the full value of your equity index annuity will pass to your heirs without the cost and delay of probate. If you’ve already annuitized your contract for a guaranteed income stream, the income option you chose will determine how much money will to your beneficiaries.
Who Can Benefit Most from an Equity Index Annuity?
Equity index annuities are a good choice for retirees or those who wish to participate in market growth and can withstand stock market volatility. Equity index annuity guaranteed rates often outperform many other investment vehicles. Index annuities are ideal for people who:
- Are looking for tax-deferred growth
- Want a minimum interest rate guarantee
- Like the idea of potentially benefit from rising markets
To know if an equity index annuity is right for you, you need to consider your individual circumstances.
Index Annuity Premium Payments
Equity index annuity owners typically have two options when making premium payments to a equity index annuity – single premium or installment premiums. With a single premium, the equity index annuity owner makes a single lump sum payment (premium) into an equity index annuity contract. With installment premiums the annuity owner has the flexibility of making a series of payments (premiums) into the equity index annuity contract.
Types of Index Annuities
There is one primary type of an equity index annuity, and that is an equity index deferred annuity. Equity index annuities go through two primary phases: accumulation and distribution. During the accumulation phase premium payments are credited based on the growth of the chosen index (such as the S&P 500). After a specified period of time the equity index annuity owner can elect to receive an income stream. Alternatively, the equity index annuity owner always has the option to cash out the equity index annuity or make systematic withdrawals.
Equity Index Annuity Crediting Methods
The performance of an equity index annuity can differ based on the annuity carrier and product. Regardless of annuity carrier or product, all equity index annuities offer a guaranteed minimum crediting rate, typically between 0% – 3%. In order to determine what the equity index annuity policy will credit based on the performance of the chosen index depends on two features of the annuity contract, the indexing method and the crediting method. Generally, equity index annuities have 3 indexing methods:
- Annual Reset: Determined by comparing the value of the index at the end of the contract year with the index value at the beginning of the year.
- High-Water Mark: Decided by looking at the index value at various points during the term, usually the annual anniversary of the date the equity index annuity was purchased. Interest is based on the difference between the highest value during the term and the index value at the beginning of the term.
- Point-to-Point: Based on the difference between the index value at the end of the term and index value at the start of the term (the term can typically vary from 1 to 10 years).
The crediting method of an equity index annuity decides how much of the increase in the index will be used to calculate the index-lined crediting rate or interest. In some cases equity index annuities will use a combination of crediting methods. Generally, equity index annuities have 4 crediting methods:
- Cap on Interest Earned: A cap limits the amount of interest an equity index annuity may be credited during the term.
- Averaging: Protects the equity index annuity owner from purchasing an annuity at its high point. The average return of an index is used to determine the value at the end of the term.
- Participation Rate: Determines how much of the increase in the index will be used to calculate the index-linked interest.
- Margin or Spread: Index-linked interest is computed by subtracting a specific percentage from any calculated change in the index.
Equity Index Annuity Payout Options
During the payout phase, the insurance company credits the annuity holder with a return that is based on changes in the chosen equity index. The annuity company makes periodic payments or one lump sum payment to the annuity holder depending on the terms of the contract. Generally, there are five types of index annuity income payout options:
1. Life Annuity: Provides annuity income for the life of the annuitant. Payments are no longer received after the annuitant passes away.
2. Period Certain Annuity: Provides annuity income for a predetermined period of time (such as 10 or 20 years) or term. If the annuitant passes away before the term is over the annuity company keeps the remaining value of the annuity.
- Life With Period Certain Annuity: Provides annuity income as long as the annuitant is alive. If the annuitant passes away before the “period certain” or term, then the designated beneficiary will receive payments for the remaining term.
- Joint and Survivor Life Annuity: Provides annuity income as long as either person named in the annuity is living. Payments are no long made after the second annuitant passes away.
- Joint and Survivor Life With Period Certain Annuity: Provides annuity income as long as both annuitants are alive. If both annuitants pass away before the “period certain” or term, then the designated beneficiary will receive payment for the remaining term.
Equity Index Annuity Things to Consider
An equity index annuity can be an important component of your financial and retirement planning, but it is important to make sure it is appropriate for you. Most problems associated with any investment are easily avoidable with the right information. When selecting the right equity index annuity for you, there are a number of considerations you should keep in mind:
- Don’t Purchase an Equity Index Annuity with Money You Need Today: Surrendering an equity index annuity prior to its maturity will trigger surrender charges and penalties.
- Investing Too Young: Withdrawals from an equity index annuity done prior to age 59 ½ will result in a 10% penalty in addition to any ordinary income taxes owed on the gain.
- Surrender Charges: Surrendering or doing a 1035 exchange to another annuity will trigger fees and penalties.
Equity Index Annuity Summary
An equity index annuity can be a very useful financial planning tool, specifically in retirement planning. Equity index annuities can help you reach retirement planning goals with the choice, control, and flexibility they offer. Equity index annuities are contracts that offer a guaranteed annual interest rate and earnings potential linked to participation in growth, if any, of a stock market index. Equity index annuity contracts have substantial variations in terms, costs of guarantees and features and may cap participation or returns. Equity index annuities are not for everyone, and should be utilized after careful consideration.
