Investors looking
to minimize risk, while still having some exposure to the stock market, may be
attracted to the equity-indexed annuity (EIA).
A relatively unique
insurance product, the EIA was created to appeal to people looking for a
financial planning solution that entails less risk than the variable annuity,
which does not offer a guaranteed rate of return but has more potential for
growth than the fixed annuity, which pays a set rate of return.
The Basics of EIAs
Unlike index mutual
funds and exchange-traded funds (ETFs), when you buy an EIA, you are buying an
insurance contract, not shares of the stocks associated with a particular
index. EIAs vary but generally promise investors who lock in a lump sum for a
specified term a guaranteed minimum return on a tax-deferred basis, with no
loss of principal.
Like an index
mutual fund, EIAs track a stock market index, such as the Standard & Poor’s
500. An EIA may, for example, provide investors with an interest rate
equivalent to 75% of the annual rise of the S&P 500, up to a maximum of
15%. If the index falls, investors still receive a minimum return for the year,
usually of around 3%.
EIAs allow you to
take advantage of market increases but offer a measure of protection during
market declines. This insurance comes at a cost – you receive a percentage of
market gains, but not all the gain an index may realize. In return, you
minimize, to some extent, your risk of loss from market declines.
Before purchasing
an EIA, weigh carefully all the features of the contract and evaluate how this
type of annuity aligns with your long-term goals. Compared with some other types
of investment products, EIAs are complex, and the specific terms of an EIA
contract can have a significant impact on returns.
A Few Questions to
Consider
Here are some common questions you may have when deciding whether a particular EIA contract
is right for you:
How long will my
money be tied up in an EIA?
Most EIAs have terms ranging from 5 to 10 years. You should consider an EIA
only if you are prepared to commit your money for the duration of the
term.
How much will I
earn when the market rises?
Buying an EIA is not the equivalent of investing directly in the stock market
or in a mutual fund. EIAs typically credit investors with a percentage of the
market gains of the index tracked, known as the “participation rate.” Many
insurance companies reserve the right to change the participation rate, and
there may be a cap placed on how much you can earn in any given year.
EIA gains are
usually based on market growth alone, and do not include dividends. EIAs
provide low hurdle rates with guaranteed principal protection, meaning you
receive the minimum rate if the index goes down and a percentage of growth when
the index goes up.
How much will I
earn if the market falls?
Depending upon your policy, your EIA may provide you with a minimum return,
even when the index to which it is linked falls. This minimum return may,
however, be based on only a portion of your original investment.
How is my gain
calculated? Companies use a
number of different methods for calculating gains. Some calculate EIA gains on
the day the policy matures, while others credit investors on an annual basis,
and still others average the gains over the entire term. Bear in mind that
differences in calculation methods may affect your returns.
What are the
penalties for early withdrawal? Some EIAs have riders allowing investors to make early withdrawals from
their policies for specific purposes, such as to cover medical emergencies or
nursing home costs. Surrender fees will apply, however, when you make
withdrawals not permitted under the terms of the contract. In addition,
accessing funds before the age of 59½ may subject you to a 10% Federal income
tax penalty.
Is my money
secure in an EIA? The
guarantees attached to EIAs are based upon the claims-paying ability of the
issuing insurance company. EIAs are not Federally insured.
What are the tax
considerations? For all
EIAs, earnings grow tax deferred and upon withdrawal will be subject to ordinary
income tax.
What are my
annuity payout options?
EIAs guarantee income for a certain length of time, which may be as long as you
live, as long as you or your spouse lives, or for another predetermined length
of time. The amount of money you receive will depend on the accumulation value
of your annuity and the annuity’s benefit rate when the payout begins.
What Should You Do?
EIAs, like other
annuities, are generally intended to provide retirees with a source of income. As
with all investments, it is important to evaluate the appropriateness of EIAs
in light of your financial goals, risk tolerance, and time horizon.
Note: Index performance is not indicative of the performance of any
particular investment, and past performance does not guarantee future results.
It is possible to lose money investing in EIAs. Investors should carefully
consider investment objectives, risks, charges, and expenses, including (but
not limited to) contingent deferred sales charges, administrative fees, and
annual contract fees.
