What Are The Pros and Cons of Equity Indexed Annuities

Growth and safety. This is the "holy grail" of investing.

These two qualities sometimes feel impossible to find, but there is a product that offers both of those features. An equity-indexed annuity provides the upside of stock market exposure while guaranteeing a minimum rate of return on your principal.

An equity-indexed annuity – also known as a fixed index annuity – is a contract between you and an insurance company, which guarantees principal protection and a future income source. The product is purchased using a lump sum or a series of payments, also known as premiums.

Equity indexed annuities are insurance products and are not directly tied to, or invested in, individual stocks. An equity-indexed annuity is a fixed annuity product which means that there is a fixed minimum guaranteed interest rate, usually between 0% and 2%.

This rate guarantee protects the buyer from downside risk due to the index volatility reflected in the ups and downs of the stock market. Sounds good so far, right? But there are challenges with this product as well, reflected in annual "caps" on growth, relative complexity, and fees. More on that later.

What is an Equity Indexed Annuity?

Equity indexed annuities are a relatively recent product phenomenon. These products were introduced back in the late 1990s as a "hybrid" of traditional fixed annuities (the most conservative type of annuity product) and variable annuities (the riskiest annuity product with the most upside potential).

It has become a very popular product for retirement planning and can be a valuable addition to your overall retirement portfolio.

Unlike regular fixed annuities, most of these annuity contracts do not pay a set rate of interest.

Instead, the growth within the contract comes from a combination of a fixed rate dictated by the insurance company and growth posted by a benchmark stock market index, like the S&P 500. There are no limits, other than those dictated by the insurance company, on deposit amounts.

Like all annuities, this product can be "annuitized" when you are in retirement to provide guaranteed income for your lifetime or a specific period of time identified by you. Equity indexed annuities have a set surrender charge period, usually up to 10 years, during which you generally have little to no liquidity.

Death benefit proceeds from an equity-indexed annuity bypass probate and goes right to the identified beneficiaries. Gains can be restricted in several ways.

First, there's something called a "participation rate." This feature reflects the portion of the total index's return you might receive in your investment's return. For instance, let's say your contract uses the S&P 500 as the linked index, and the S&P gains 10% in a year.

If your participation rate was 100%, then your return would be 10%. If the participation rate was 70%, you'd be credited with 7%.

Your contract may also have a “cap rate”. The cap is a specific limit on how much the insurer allows you to earn each month or each year, depending on the contract.

If the monthly earning cap is 1% per month, then even in a month when the S&P 500 surges 5% you'll earn no more than 1%.

However, the benefit of this type of annuity is that even when the S&P loses 5% in a month or year, you will be credited with the contract’s minimum guaranteed crediting rate. Fixed index annuities do not charge an upfront fee. Instead, the annuity company will deduct its fees from your account balance each year for any optional account riders you have selected.

Expenses

Possible fees can include mortality expenses. Also known as M&E fees, these cover the expected cost to the annuity company for its future income guarantees. It also covers the company’s costs for selling the contract. Administration fees. The fixed index annuity may charge an additional administration fee each year. Riders. When you sign up for an annuity, you can choose to purchase riders that provide extra benefits for the contract. For example, you could buy one that guarantees a minimum return over the life of the contract. You’ll pay an annual fee for each rider.

Tax treatment

An equity-indexed annuity contract is taxed just like other types of annuities.

All money inside these contracts grows tax-deferred until you take distributions. Once you begin to take the money out in retirement, the money is reported to the IRS and ordinary income tax is due. Remember that any distribution taken before age 59 1/2 is subject to an additional 10% early withdrawal penalty by the IRS.

Pros

• Like all annuity contracts, equity-indexed annuities can be used for lifetime income.
• Taxes are deferred on gains until they are withdrawn in retirement.
• Limited downside during downturns in the market.
• Better potential returns than most bonds or certificates of deposit (CDs).
• Can be passed along to beneficiaries without worrying about probate.

Cons

• With an equity-indexed annuity, you don’t receive the exact return of the market index upon which your contract is based. Instead, the annuity will limit both your potential gains and your losses. If the index does not perform well, you could actually earn less money than you would with a MYGA fixed annuity since the guaranteed minimum fixed rate on equity-indexed annuities can be as low as 0%.
• Limited upside potential when the market is doing well.
• Can be fee-heavy depending on the contract and riders that you choose.
• IRS tax penalties for withdrawals prior to age 59 1/2.

Is an Equity Indexed Annuity Right for You?

As you've read, equity-indexed annuities could have a place in your retirement portfolio but are not without potential issues. Because the product can be complex, a meeting with a financial advisor to discuss your overall plan is a good idea.

Contract terms with this type of annuity are very important and should be spelled out clearly by your agent. If you are looking for more of a "sure thing," you may want to consider a fixed annuity from Canvas Annuity. Canvas annuities are MYGAs or multi-year guaranteed fixed annuities, and current rates are very attractive (up to 3.25% a year!). Canvas annuities can be purchased directly online or via a licensed contact center agent.