What Are Equity-Indexed Annuities and How They Work

An equity-indexed annuity (EIA) is a contract between an individual and an insurance company. It blends characteristics of both traditional fixed annuities and variable annuities. EIAs offer growth potential linked to a stock market index, such as the S&P 500, while protecting the principal investment from market downturns. This design aims to provide more potential interest credits than a traditional fixed annuity without the direct market risk of a variable annuity.

Understanding Equity-Indexed Annuities

Equity-indexed annuities are distinguished by their dual nature, combining principal protection with market-linked growth potential. The insurance company credits interest to the annuity based on the appreciation of an external market index. This structure ensures the initial premium is safeguarded, protecting the contract owner against market losses. Unlike direct investments in the stock market, an EIA does not directly invest funds into the index. Instead, the annuity’s returns are linked to the index’s performance, but the principal is held in the insurance company’s general account, often backed by high-grade corporate and treasury bonds.

The insurance company manages the funds, providing the guarantees and determining how much interest is credited. Various recognized market indices can be used, with the Standard & Poor’s 500 (S&P 500) being the most common. Other indices, such as the Nasdaq 100 or Russell 2000, may also be available. The use of an index allows for participation in potential market gains without direct exposure to market volatility and loss of principal.

How Equity-Indexed Annuity Returns Are Calculated

The credited interest for an equity-indexed annuity is determined by several mechanisms. These mechanisms include indexing methods, participation rates, interest rate caps, spreads or asset fees, and floor rates.

Indexing Methods

Indexing methods define how the change in the linked index is measured to determine the interest credited. The annual reset method is a common approach. With this method, interest is calculated based on the index’s performance over each contract year, and any gains are locked in annually, while losses are ignored for that year. The starting point for calculating future interest resets each year, allowing previously credited interest to be protected from subsequent market declines. For instance, if an index starts at 1,000 and rises to 1,100 in the first year, the 10% gain is credited, and the new starting point for the next year’s calculation becomes 1,100.

The point-to-point method measures the growth of the index from one specific point in time to another, typically from the beginning of the contract term to the end. Fluctuations in the index’s value during the term are generally disregarded; only the starting and ending values matter for the calculation. For example, if an index begins at 1,000 and ends at 1,200 after a five-year term, the gain is 20%, regardless of interim highs or lows. Another method is the high-water mark, which uses the highest index value reached over a specified period, often the entire contract term, compared to the starting value. If an index starts at 1,000 and peaks at 1,300 before ending at 1,100, the high-water mark method would use the 1,300 value for calculating the gain.

Participation Rate

A participation rate determines the percentage of the index’s gain that is credited to the annuity. For example, if an EIA has an 80% participation rate and the linked index increases by 10%, only 8% (80% of 10%) of that gain would be credited to the annuity. Participation rates commonly range from 70% to 90% in the initial years of the contract. This rate may be adjusted by the insurance company at the start of each new contract term.

Interest Rate Cap

An interest rate cap, or cap rate, sets an upper limit on the interest rate that can be earned in a given period, regardless of how high the index performs. If an annuity has a 6% cap and the index grows by 10%, the annuity would still only be credited with 6% interest for that period. This limitation helps the insurance company manage its risk and provide the principal guarantees.

Spread or Asset Fee

Some EIAs may also include a spread or asset fee, which is a percentage deducted from the index’s gain before interest is credited. For instance, if the index gains 10% and a 2% spread is applied, the credited interest would be based on an 8% gain. This fee can be applied in addition to, or instead of, a participation rate.

Floor Rate

The floor rate represents the minimum interest rate credited to the annuity, ensuring that the annuity’s value will not decrease due to negative index performance. Most equity-indexed annuities have a 0% floor, meaning that if the linked index declines, the annuity will not lose value, and no interest will be credited for that period. Additionally, state insurance laws often require a guaranteed minimum interest rate if the annuity is held to the end of its surrender term. This minimum guarantee provides a safeguard against prolonged periods of flat or negative market performance.

Key Features and Practical Considerations

Equity-indexed annuities incorporate several features and considerations important for potential contract owners. The principal protection characteristic of an EIA means that the initial investment is secured against market downturns. This protection ensures that the amount paid into the annuity will not decline due to negative index performance, distinguishing EIAs from direct stock market investments.

Earnings within an equity-indexed annuity grow on a tax-deferred basis. This means that taxes on the interest credited are postponed until withdrawals are made from the contract, typically during retirement. When withdrawals occur, the earnings are taxed as ordinary income.

Accessing funds from an EIA typically involves liquidity considerations and potential charges. Most EIAs have surrender charge periods, often ranging from 5 to 10 years, during which early withdrawals may incur penalties. Many contracts allow for limited penalty-free withdrawals, such as 10% of the account value annually. Withdrawals made before age 59½ from a non-qualified annuity may also be subject to a 10% federal income tax penalty, in addition to regular income taxes on the taxable portion of the withdrawal.

Upon the annuitant’s death, an EIA typically includes a death benefit, which is paid to the designated beneficiaries. This feature ensures that the accumulated value, or a guaranteed minimum, is transferred to heirs, bypassing the probate process.

Like other annuities, EIAs offer annuitization options, allowing the contract owner to convert the accumulated value into a stream of guaranteed income payments. These payments can be structured to last for a specified period or for the lifetime of the annuitant, providing a predictable income source in retirement.

Beyond the spread or asset fee used in interest calculation, other fees and charges may apply to an EIA. These can include administrative fees or costs for optional riders, which provide additional benefits such as enhanced death benefits or guaranteed living benefits.