Equity-indexed Annuity
What is an equity-indexed annuity?
An equity-indexed annuity is a fixed, tax-deferred annuity like others defined on this website. What makes this type of annuity different is how the gains are credited. Instead of crediting a company-declared interest rate of say 4, 5 or 6 percent, the gains are linked or indexed directly to the growth performance of a leading stock market index, such as the S&P 500. Like other fixed annuities, there is a 100% guarantee of principal plus minimum interest (usually around 3 percent). An individual cannot lose a penny, as long as he or she stays in the contract for the full contract term. Unlike other fixed annuities, however, the owner has the potential to make more money if the index goes up. And if the index goes down? No problem - the owner does not lose anything and is still guaranteed 100% of principal plus minimum interest. (And because there are no sales charges, management fees, expense charges or mortality costs, 100% of the premium is used to accumulate funds. Plus, equity-indexed annuities are tax deferred, so no tax is paid on the gains as long as those gains remain in the contract.) Basically, equity-indexed annuities provide an incredible opportunity to invest in the stock market with absolutely no risk!
How does the volatility of the S&P 500 affect an equity-indexed annuity?
The vast majority of equity-indexed annuities are linked to the S&P 500 Index (although some may be indexed to the Nasdaq, Dow, Russell 2000, etc). As the name indicates, the S&P 500 consists of 500 U.S. stocks from 10 economic sectors. These are not necessarily the 500 largest companies, but all of these stocks are widely held and the total market value of the 500 exceeds $6 trillion. The S&P 500 represents 80 percent of the market value of companies on the New York Stock Exchange. This index is widely regarded as the most accurate benchmark for overall stock market performance.
No one knows for sure how the stock market or the S&P 500 is going to perform in the future, but most people agree that one of three things will happen:
One - The index could go down each and every year . In this case, the owner would simply get all of his or her money back plus a small return. It is guaranteed that not a penny can be lost!
Two - The index could go up each and every year . In this case, the owner would get all of his or her money back plus a large percentage of the index gains.
or Three - The index could go up and then go down over the next few years. In this case, the account value would be credited with the gains but not affected by the declines. The account value can only go up and can never go down.
How are the interest earnings determined for an equity-indexed annuity?
The interest earnings are ultimately determined by the movement of the S&P 500. To translate the index movements into actual credited gains, however, a crediting method must be used. There are three basic crediting methods used with equity-indexed annuities - Annual Reset (Ratchet) , High Water and Point-to-Point.
The Annual Reset method, or Ratchet method, is perhaps the most versatile of the three methods. This method measures each year's market performance from contract anniversary to contract anniversary. If the market goes up, a gain is credited for that year, and the new value generally forms the basis for any future compounding of annuity gains. This new value can never be reduced, regardless of any market declines. So if the market goes down the next year, the annuity is simply credited zero, with no reduction to the accumulation value. And at the end of each contract year, the S&P 500 Index starting point is reset to measure the change in the market for the next year. (Hence the name "Annual Reset".) So according to the graph, the annuity would be credited a gain at the end of the 1st year because the market went up. For the 4th year, however, the market went down, so the annuity would be credited zero. Yet this crediting method is good for when the market is going down because the new starting index level will be low for the 5th year, providing greater growth potential.
The second method is the High Water method. With this method, the index gain is the difference between the index level at contract issue and the highest index level achieved at any of the contract anniversaries. Therefore, the index gain cannot be determined until the end of the entire contract term. At the contract end, this method has a "look back" feature to determine the highest index level achieved during the contract term, called the "High Water Value." The owner would then be credited a gain based on this "High Water Value." So according to the graph, market went up, up, up and then down, down, down, the owner would benefit from the high value achieved at the end of the 5th year, without being affected by any of the subsequent declines.
The third method is the Point-to-Point method. This crediting method is the easiest for a company to administer. As the name describes, the index gain is simply measured as the difference between two points - the starting index level at the beginning of the contract and the ending index level at the end of the contract term. This method ignores all of the fluctuations between the beginning and the end. Nothing is credited in between nor does the annual statement reflect any credited gains until the end of the term. According to the graph, at the end of this contract term, the owner would be credited a gain based on the index growth. However, if there is a market correction at the end of the contract term, an owner could lose all or part of the previous growth. The original deposit, however, remains unaffected, and the owner would still receive at least minimal interest.
Many companies also use averaging techniques with the crediting method to help smooth out downward movement. Averaging can be done daily, monthly, quarterly or semi-annually. These averaging techniques greatly ease the risk of having the gains be reduced or eliminated through the misfortune of determining the S&P 500 value at one single point in time. It reduces the impact of short-term declines while retaining strong growth potential. The disadvantage of averaging is felt only in large growth performance years.
In addition to averaging, there are a few other factors that affect the potential credited gains, namely participation rates , spreads (margins) and caps . The participation rate is the percentage of the gain of the S&P 500 that the owner receives or participates in. For example, if the S&P 500 experienced a growth of 15% and the annuity contract guaranteed a participation rate of 75%, the owner would receive a 11.25% increase (15% × 75%). A spread is a percentage that is deducted from the index growth before being credited to the annuity. For example, if the index experienced a growth of 15% and the annuity contract stated a spread of 2.5%, the owner would receive a 12.5% increase (15% - 2.5%). Finally, a cap is a maximum percentage that can be credited. No matter how much the market goes up, the owner can never receive a credited gain that is higher than the cap. For example, if the index experienced a growth of 15% and an annuity contract is set up with a 10% cap, the owner would receive no more than a 10% increase.
In short, the equity-indexed annuity marketplace has many different product designs, approaches and variations of the three basic crediting methods. And new possible variations and combinations are being introduced all the time. Just remember that there is no magic in the design of any of these crediting methods. There is a simple investment strategy that supports each and every design variation. Contact us so we can help you to determine which crediting method design has the features and benefits best suited to fulfill your individual needs.
Why choose an equity-indexed annuity?
Many people agree that the stock market offers the greatest opportunity for growth. However, for many of us it is our perception of the risk associated with the market that keeps us from participating in this growth potential. What is so exciting about this concept is that you can now participate in the growth potential of the stock market with the peace of mind that your principal is 100% Guranteed never to be less that your initial investment!
