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What Are Equity Indexed Annuities?

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Equity indexed annuities are considered a form of variable annuities. Unlike fixed annuities that grow only by interest earnings at a fixed rate, variable annuities invest in various asset classes: stocks, bonds, and etc. and as a result, investment returns may vary depending on the performances of the markets that an annuity happens to be involved in. If an annuity has its investments tied to the performance of a particular stock index, returns of the annuity likely fluctuate along with the performances of all the stocks that make up the index and could potentially turn to negative at times, losing some of the initial investment. And so, it’s important that equity-linked annuities are given a longer time horizon to absorb the risks, as longer-term investments can perform better. Thus, annuities tied to equities are often deferred annuities, rather than immediate annuities.

Fee for Guarantee

Variable annuities, equity indexed or by other means, are attractive to certain annuity investors because of its potential upside returns, but the fear of losing money is also a reality. To lessen that concern, annuity providers would offer an guaranteed minimum rate of return upon withdrawn, even if an account had lost value. To exchange for such a safety measure, annuity investors agree to pay a fee, knowing that a market’s out-performance could well compensate for the cost. For annuity providers, fee charges on accounts that never lose value are used to cover any minimum payments on accounts that do lose value, given that not all investors have the same investment time line.

Other Structural Elements

When annuities are indexed to the performances of other equities, calculating gains and returns for the annuities can be much more complex than compounding a simple interest rate on a traditional, fixed annuity. Returns for annuity investors on an equity-linked annuity are generally affected by the following 3 factors: participation rate, interest rate cap, and spread or asset fee, which could be mutually exclusive. Participation rate is the percentage at which total gains experienced by related equities are credited to the annuitant’s account. Interest rate cap is the maximum rate of return allowed by the annuity provider to be earned on the annuitant’s account, regardless of any higher performances of the equities. Or alternatively, such an annuity provider can charge an asset management fee or spread, expressed in a percentage rate, to be subtracted from the investment rate of return achieved by the equities.

In conclusion, combining annuity features from both fixed and variable ones, annuities that are equity indexed with a minimum, guaranteed payout do not have as much risk as a typical variable annuity does, but may not return as much either. On the other hand, they are riskier than fixed annuities but can also earn higher returns if their equity market goes well.