Stock-indexed annuities are contracts between individuals and insurance companies that offer guaranteed income based on the performance of a specific stock market index. They are not considered stocks and offer a guaranteed minimum return, but also have participation rates, caps, and spreads that limit potential earnings. The method of calculating index gains can also impact earnings. These annuities are not suitable for most senior investors due to significant redemption charges, but may be viable options for young investors with sufficient capital. Investors should carefully review all terms of the contract.
An annuity is a contract between an individual and an insurance company in which the buyer, or lender, makes a lump sum payment or series of payments in exchange for guaranteed income at a later date. Stock indexed annuities (EIA) are annuities whose returns are based on the performance of a specific stock market index. Although annuities are available in several countries, EIA is only available in the United States.
In the United States, fixed annuity contracts are considered insurance products that are not regulated by the Security Exchange Commission (SEC). Variable annuities, on the other hand, are invested in mutual funds and come under the oversight of the SEC. Stock-indexed annuities are a hybrid that are generally not considered stocks. Like fixed annuities, they offer a guaranteed minimum return, usually 90% of premiums paid, plus at least 3% interest. By linking the rate of return to an equity index, they also offer the opportunity to profit from market fluctuations without the risks of variable annuities.
A stock index tracks the performance of a particular group of stocks relating to the same sector of the stock market or economy. In the United States, some of the larger indexes include the Dow Jones Industrial Average (DJIA), the S&P Composite Stock Price Index, and the NYSE Composite Index, among others. Before purchasing an EIA, a person should investigate the performance of the Annuity Index.
The amount of return paid by stock-indexed annuities is not necessarily equal to the actual return on the index. Most EIA agreements include a participation rate, which is the percentage of the earnings that will be used to calculate the yield. For example, if the contract has an 80% participation rate and the index increases by 10%, the annuity will pay only 8% (80% of 10% = 8%). Some contracts also include a maximum, or cap. If the cap is 7% and the index increases by 10%, the maximum rate paid will be 7%.
Another limiting factor is the margin/spread/administration fee charged by some stock indexed annuities. This is a percentage of the earnings on the index retained by the insurance company. If a contract has a spread of 3.5% and an index grows by 9%, the maximum rate paid by the annuity will be 5.5% (9% – 3.5% = 5.5%). Some EIA contracts allow the insurer to adjust the rates of interest, caps and spreads from time to time.
How the amount of change in the linked index is calculated is another important factor in determining the earning potential from stock-indexed annuities. Some calculate the change every year. Any losses are ignored, but any gains are blocked and credited to the account. This can be beneficial as long as the contract has no caps and low participation rates.
Another method for calculating index gains is the point-to-point method. This generally compares the index values at the start and end date of the contract. If there is a net gain, that is the amount paid, subject to other contractual restrictions. A significant downside occurs if the index performed well during the intervening years but fell immediately before the end date, resulting in no benefit for the annuitant.
The high water mark method of determining the index gain can provide the best rate of return. This method records values at the start of the contract term and at various benchmarks throughout the term of the contract. The high point is then used to calculate the index gain. As long as a person doesn’t need to forego their annuity early and doesn’t have low limits or participation rates, principal-indexed annuities using this calculation are the most beneficial.
Stock-indexed annuities are intended to be held long-term and usually incur significant redemption charges. Tariffs are phased out over time, but it can take 10 to 15 years to be completely phased out. Early redemption may actually result in the loss of a portion of the initial payment. For this reason, these are not considered an appropriate vehicle for most senior investors.
Young investors with sufficient capital not to worry about the need for an early withdrawal may find viable options for stock-indexed annuity. They offer the benefits of a guaranteed minimum return, as well as the ability to benefit from stock market increases, without the associated risks. These can be quite complicated products, however, so an investor should be very careful to review all terms of the contract.
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