Equity-Indexed Annuities: What You Need to Know

Indexing Methods

As described below, there are several methods for determining the change in the relevant index over the period of the annuity. These varying methods impact the calculation of the amount of interest to be credited to the contract based on a change in the index.

Annual Reset (Rachet). Compares the change in the index from the beginning to the end of each year. Any declines are ignored.

Advantage: Your gain is "locked in" each year.

Disadvantage: Can be combined with other features, such as lower cap rates and participation rates that will limit the amount of interest you might gain each year.

High Water Mark. Looks at the index value at various points during the contract, usually annual anniversaries. It then takes the highest of these values and compares it to the index level at the start of the term.

Advantage: May credit you with more interest than other indexing methods and protect against declines in the index.

Disadvantage: Because interest is not credited until the end of the term, you may not receive any index-link gain if you surrender your EIA early. It can also be combined with other features; such as lower cap rates and participation rates that will limit the amount of interest you might gain each year.

Point-to-Point. Compares the change in the index at two discrete points in time, such as the beginning and ending dates of the contract term.

Advantage: May be combined with other features, such as higher cap and participation rates, that may credit you with more interest.

Disadvantage: Relies on single point in time to calculate interest. Therefore, even if the index that your annuity is linked to is going up throughout the term of your investment, if it declines dramatically on the last day of the term, then part or all of the earlier gain can be lost. Because interest is not credited until the end of the term, you may not receive any index-link gain if you surrender your EIA early.

EIA Notes

Index Averaging. Some EIAs average an index's value either daily or monthly rather than use the actual value of the index on a specified date. Averaging may reduce the amount of index-linked interest you earn.

Interest Calculation. The way that an insurance company calculates interest earned during the term of an EIA can make a big difference in the amount of money you will earn. Some EIAs pay simple interest during the term of the annuity. Because there is no compounding of interest, your return will be lower.

Exclusion of Dividends. Most EIAs only count equity index gains from market price changes, excluding any gains from dividends. Since you're not earning dividends, you won't earn as much as if you invested directly in the market.

Can I get my money when I need it?

EIAs are long-term investments. Getting out early may mean taking a loss. Many EIAs have surrender charges. The surrender charge can be a percentage of the amount withdrawn or a reduction in the interest rate credited to the EIA.

Also, any withdrawals from tax-deferred annuities before you reach the age of 59½ are generally subject to a 10% tax penalty in addition to any gain being taxed as ordinary income.

Do EIAs and other tax-deferred annuities provide the same advantages as 401(k)s and other before tax retirement plans?

No, 401(k) plans and other before-tax retirement savings plans not only allow you to defer taxes on income and investment gains, but your contributions reduce your current taxable income. That's why most investors should consider an EIA and other annuity products only after they make the maximum contribution to their 401(k) and other before-tax retirement plans.

Is it possible to lose money in an EIA?

Yes. Many insurance companies only guarantee that you'll receive 90% of the premiums you paid, plus at least 3% interest. Therefore, if you don't receive any index-linked interest, you could lose money on your investment. One way that you could not receive any index-linked interest is if the index linked to your annuity declines. The other way you may not receive any index-linked interest is if you surrender your EIA before maturity. Some insurance companies will not credit you with index-linked interest when you surrender your annuity early.

If you have questions about EIAs, you can contact your state insurance commissioner. You can check out whether the person selling an EIA is registered with FINRA. Check FINRA BrokerCheck or call the FINRA hotline at [phone].