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!
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.
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 years 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% Χ
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.
