Equity Indexed Annuities (EIAs): A Hybrid Annuity with Fixed and Variable Characteristics

by Rob Phillips, CPA

An equity indexed annuity is a unique annuity that offers characteristics of both a fixed and a variable annuity. This makes it possible for you to benefit from potential gains in a stock market index, while still receiving a guaranteed minimum return, based on the issuer’s ability to pay.

The return offered by this hybrid varies more than a fixed annuity, but not as much as a variable annuity. It offers more risk, but potentially more return than a fixed annuity, and less risk, but potentially less return than a variable annuity.

Equity indexed annuities offer a minimum guaranteed return based on the issuer’s ability to pay combined with an interest rate linked to a market index. Because of the guaranteed interest rate, equity indexed annuities have less market risk than a variable annuity, but also offer potential to earn returns better than a fixed annuity when the stock market is rising.

How Equity Indexed Annuities Work

Typically, an equity indexed annuity is linked to a market index such as the S&P 500 stock index (one that tracks the performance of a certain group of stocks). If the index goes up, your equity indexed annuity is credited with a return based on a percentage of the gain in that index.

This gain is not paid annually, but at predetermined times during the life of the annuity. With some contracts, the waiting period may be several years and if the contract is surrendered prior to the expiration of the waiting period, only a nominal rate of growth may be credited.

However if the bottom should drop out of the market, the advantage of an equity indexed annuity is that you are still entitled to a minimum interest rate on your investment as promised by the issuing insurance carrier.

Remember that in years when the index loses value, your equity indexed annuity account is credited with the minimum rate your contract provides, like a fixed annuity.

How to Compare

It can be difficult to compare equity indexed annuities offered by various annuity companies, but here are some questions to consider as you conduct your research.

How much does my equity indexed annuity earn when the market goes up?

Your earnings are linked to the participation rate specified in the contract. Typically the participation rate set by the issuing insurance company ranges from 50% to 90% of the index price gain (excluding dividends and net profits a company distributes to stockholders). Make sure to consider a defined benefit plan.

Is there an annual cap, or maximum amount of interest, that will be credited to my annuity?

Many companies limit the amount of index gain that will be added to your equity indexed annuity account. The caps vary from company to company and vary from year to year. Additionally, some companies limit the amount the assets may grow in any given month.

What rate do I earn if the market does down?

If the market does down, you are still entitled to the minimum interest rate promised by the issuing insurance carrier. Some companies guarantee the rate for the annuity’s guarantee period and some are adjusted annually.

How much do I lose if I surrender my annuity early?

Compare the surrender fees and the different products and how long they are in effect. Most are a percentage of the assets, which decline of the first seven years and then disappear. With some contracts, the benefits of partial participation in market growth are invalidated if the investor takes partial withdrawals or surrenders, or fails to reinvest all of the annuity’s earning. Additionally, a 10% tax penalty may apply for premature surrender or in the case of an owner-only cash balance plan.

The Cost of Guarantees

While the return on equity indexed annuities is based on the performance of a stock market index, you do not get the full reward of the rising market, nor do you risk the full impact of a falling one. Instead, you get a percentage of the amount the index gains over a period of time, but not dividends or net profits a company distributes to stockholders.

Getting Information

Experts agree that equity indexed annuities are complex products, and urge you to be sure you understand how they work before you put money into them. 

  • NASD offers information regarding equity indexed annuities in an “Investor Alert” located in the “Investor Information” section of their website www.nasd.com
  • Information is available from the National Association of Insurance Commissioners at 816-842-3600 or check their website www.naic.org.

Fixed Annuities: Market Value Adjustment (MVA)

There are some fixed annuities, called Modified Guarantee Annuities that include a market value adjustment (MVA) feature. This adjustment is made in the event you want to surrender your annuity or possibly in instances where you make withdrawals.

One reason you might choose to do this, is if interest rates have increased substantially and you want to purchase another fixed annuity paying a higher rate—or if you need the money for any purpose. What the MVA does, in effect, is shift some of the investment risk from the company to you.

The annuity company invests your premium in order to be able to pay you the rate guaranteed in your contract; it could lose money if it had to sell those investments at a discount to refund your premium plus your earnings.

So it uses a fixed formula to figure the adjustment, or the amount you must pay from your earnings, for withdrawing money under these circumstances. In the event that you withdraw your premium at a time when interest rates have declined, you may receive a smaller amount.

On the other hand, the annuity company could realize a gain when it sells the investments. In that situation, the market value adjustment formula may result in your receiving a higher amount.

Different contracts that include MVA features may have different provisions. One of these provisions might include whether it has the right to take some of your principal to make a negative adjustment or whether you are assured the right to keep at least a minimal percentage of earnings. It is an important factor to include in your purchase decision.

However, you may discover that to compensate you for the potential risk you take, fixed annuities with an MVA feature offer higher earnings potential than those offered by other fixed annuities. Another advantage is that fixed annuities with MVA features also typically offer longer interest rate guarantee periods than other fixed annuities.

In other words, as with all other investment programs, what might be the best fixed annuity for one person isn’t always good for another. Our planners and financial specialists can provide assistance to evaluate the alternatives and determine what would work best for your personal investment plan.

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