Equity indexed annuities

Equity indexed annuities, or EIAs, are a relatively new form of fixeddollar annuities. They blend minimum insurance company guarantees with linking the annuity’s interest earnings to a stock market index, such as the S&P 500. While there are many different designs of EIAs being sold, we use just one as an example.

Let’s say you invest $50,000 as a single-premium deferred EIA. The particular policy you purchase will guarantee a minimum value of 85 percent, or $42,500, of your principal amount. The value of the EIA will not fall below the minimum guaranteed value, which is $42,500 in this example. Plus, if it is higher, the EIA will pay a percentage of the increase in an equity index over a specified time period. The percentage paid will vary among the different insurers, and even the different EIAs offered by the same insurer. For this example, we’ll use 80 percent. We’ll also use the S&P 500 as our stock index and 10 years as our time frame. The percentage of the index increase is called the “participation rate.” Therefore, if the increase in the S&P 500 Index over the 10 years were 60 percent, the interest credited for this increase would be $24,000. Therefore, the accumulated value of the EIA would be $74,000, which is greater than the minimum. The annuity could then continue to earn interest in this manner. If the S&P 500, or another unmanaged index, were to decline, the EIA wouldn’t fall below its guaranteed minimum of $42,500.

Participation  rate = 80% S&P 500 increase = 60%

Initial  premium = $50,000

Interest  = 80% - 60% - $50,000

Interest  = $24,000

Contract  value = $74,000

(All  amounts are hypothetical.)

The returns on EIAs may be subject to certain limitations. For instance, there may be a cap on the amount of interest the annuity can be credited with. Plus, there are features that will also limit the return, such as which index is used, the participation rate, how the interest based on the index is calculated, the guaranteed minimum account value, and any possible account charges. Not only are there a number of different stock indices used, there are different participation rates (which may range anywhere from 50 to more than 100

percent) and different methods of calculating the interest. EIAs are considered to be equity investments because they are tied to stock market indices. However, their returns will perhaps not be as great as other equity investments, such as stocks or mutual funds, due to participation rates being less than 100 percent, possible interest rate caps, and because equity indices usually don’t include dividends paid on common stocks in the index. Rather, they are indices of the market prices of stocks.

EIAs are just like other annuities. They can grow on a taxdeferred basis and all interest and gain on the annuity contract is taxed at ordinary income tax rates once distributions have begun. For nonqualified EIAs, the principal amount comes out tax-free to the owner. (Other taxes may apply.) But, all taxes must be paid once withdrawals begin, and for those who are younger than 591/2, there may be an IRS penalty of 10 percent.