Explaination of Equity Index Annuity

2006-01-15

An equity index annuity can be said to be a combination of the low-risk fixed annuity and the high risk variable annuity. Equity index annuities are offered by insurance companies and are frequently used in the United States to accumulate money and save for old age. The variable annuity offers a potentially high return, but is also connected to a high risk and the investor can loose all the money if the value of the variable annuity drops. The fixed annuity is a safe investment since the interest rate is predetermined in the contract and will not be affected by swings on the financial markets. With a fixed annuity you will however not be able to benefit from increased values on the financial market.

The equity index annuity was created in order to provide the investors with a middle-rood. With an equity index annuity, you will be able to benefit from a well performing financial market but still be safeguarded against loosing your invested money. An equity index annuity will be linked to the changes in a major equity index, such as the Dow Jones Industrial Average or the S&P 500. Almost all the equity index annuities come with a guarantee that protects your investment. You can for instance be guaranteed at least 90 percent of the initial purchase value regardless of how the market performs in reality. A lot of insurance companies will also offer a guaranteed minimum return rate on your equity index annuity.

Before your purchase an equity index annuity you should always check what will happen if you cancel your equity index annuity early or if you need to withdraw a part of the money in advance. It is common for equity index annuities to have rather large fees and penalties for early withdrawals and some insurance companies will not credit you the index-linked interest if you make early withdrawals. Also remember that early cancellation or withdrawals can affect the beneficial tax treatment and you might face tax penalties. This is not only valid for equity index annuities, all forms of deferred annuities where the investor is granted beneficial tax treatment under the U.S. tax law can be affected by early cancellations and early withdrawals.

When you choose between different equity index annuities you should always look at the Participation Rates, the Interest Rate Caps and the Margin/Spread/Administration Fee. Equity index annuities can be very intricate contracts and you should not only look at these three factors since other regulations can affect the equity index annuities significantly. The size of the participation rates will be the factor that determines how much of the index\'s increase that will be included when your index linked interest rate is calculated. If you purchase an equity index annuity where the participation rate is 85 percent and the index increases with 8 percent, your return will be 8% x 85% = 6.8%. Some equity index annuities will also come with interest rate caps. The “caps” are upper limits, and the interest rate cap of you equity index annuity will determine how large your maximum interest can be. If your equity index annuity has a cap that is 6 %, and you should receive 6.8% as in the example above, you will still receive no more than 6 %. For many annuities, a certain percentage will always be subtracted from any gain. This fee is called different things in different contracts, e.g. administrative fee, spread or margin. If you purchase an equity index annuity where this fee is 2 percent, 2 percent will be subtracted from the index. If the index gains 8%, the return credit to your annuity will therefore be 8 – 2 = 6

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