Equity-Indexed Annuity: How They Work and Their Limitations

An equity-indexed annuity is a type of fixed annuity that is distinguished by the interest yield return being partially based on an equities index, typically the S&P 500.

The general appeal of equity-indexed annuities is to moderately conservative investors who like having some opportunity to earn a higher investment return than what's available from traditional fixed-rate annuities, while still having some protection against downside risk. But they are complex and have some disadvantages to keep in mind if you are considering purchasing one.

How an Equity-Indexed Annuity Works

An annuity is essentially an investment contract with an insurance company, traditionally used for retirement purposes. The investor receives periodic payments from the insurance company as returns on the investment of premiums paid. There is an accumulation period when the premiums paid earn interest in accordance with the terms of the annuity contract, followed by a payout period.

In the case of equity-indexed annuities, also commonly referred to as indexed annuities, part of the interest rate earned is a guaranteed minimum, typically 1% to 3% paid on 90% of premiums paid. The other part is linked to the specified equities index.

Earnings from equity-indexed annuities are usually slightly higher than traditional fixed-rate annuities, lower than variable-rate annuities, but with better downside risk protection than variable annuities usually offer.

Special Considerations

A key feature of equity-indexed annuities is the participation rate, which basically limits the extent to which the annuity owner participates in market gains. If the annuity has an 80% participation rate, and the index to which it is linked shows a 15% profit, the annuity owner participates in 80% of that profit, realizing a 12% profit.

In return for accepting limited profits, investors receive protection against downside risk, usually a guarantee of at least breaking even each year that interest is earned in terms of the equity index portion of earned interest. Some equity annuities also have an absolute cap on total interest that can be earned. Another aspect to consider is whether or not interest earned is compounded.

Indexed annuities use one of three calculation formulas to determine the changes in the equity index level that interest payments are calculated from. The most common is the annual reset formula, which simply looks at index gains and ignores declines. This approach can be a substantial benefit during down years in the stock market.

A second formula, the point-to-point method, averages the index-linked return from the index gains at two separate points in time during the year.

The third option, the high-water mark, looks at the index values at each anniversary date of the annuity and selects the highest index value from those to then be averaged with whatever the index value was at the beginning of the payment term.

Limitations of Equity-Indexed Annuities

One disadvantage of equity-indexed annuities is high surrender charges. If the annuity owner decides to cancel the annuity and access the funds early or before the age of 59½, cancellation fees can run high, in addition to a 10% tax penalty. Historically, equity-indexed annuities have also been subject to high commission fees.

Equity-indexed annuities are complex and there are numerous factors that can significantly affect the investment's potential profitability. Some analysts question whether these annuities can be considered a good investment at all.

Like any investment, it's key to understand how equity-indexed annuities work, and the risks involved, before deciding to purchase one.