7.6.1 Indexed Annuities
Indexed annuities (IAs) were established in the mid-1990s by insurance companies to compete with very popular indexed mutual funds.
Although the stock market and the S&P 500 index regularly move up and down over time, the averaging process smooths out the peaks and valleys, minimizing the risk. Once the contract has been credited with its gain for a particular year, the gain can never be taken away. If the market should experience a fall in value, the equity indexed annuity is protected.
Generally, the annual investment returns are tied to a percentage (about 85%, subject to periodic adjustments) of the S&P 500's gains, but this does not include dividends. This cap on gains is offset by protection against market losses. The surge in indexed annuity sales attests to their popularity in the marketplace.
The designated time period for an equity indexed annuity is seven years. Many insurance companies have touted the benefits of the long-term investment in equity indexed annuities by pointing out positive features.
- A 100% risk-free CD alternative
- Potential growth in the stock market with no risk to premium
- Both growth and safety in the same tax deferred vehicle
- If the market goes down, the investor gets all of the principal back at the end of the term
- If the market goes up, the investor gets all of the principal back at the end of the term PLUS a large percentage of the market increase
An equity indexed annuity is different from other fixed annuities because of the way it credits interest to the annuity's value. Most fixed annuities credit interest calculated at a rate set in the contract. Equity indexed annuities credit interest using a formula based on changes in the index to which the annuity is linked. The formula decides how the additional interest, if any, is calculated and credited.
The equity indexed annuity also promises to pay a minimum interest rate. The rate that will be applied will not be less than this minimum guaranteed rate even if the index-linked interest rate is lower. The value of the annuity will not drop below a guaranteed minimum. For example, many single premium annuity contracts guarantee the minimum value will never be less than 90% (100% in some contracts) of the premiums paid, plus at least 3% in annual interest (less any partial surrenders). The insurance company will adjust the value of the annuity at the end of each term to reflect any index increases.
Two features that have the greatest effect on the amount of additional interest that may be credited to an equity indexed annuity are the indexing method and the participation rate.
