Do equity indexed annuities allow me to participate in the stock market?


Equity indexed annuities have only been on the market for a number of years, and like most relatively new products, they are of hybrid nature.

An equity indexed annuity shares the characteristics of both fixed and variable annuities, allowing limited participation in the stock market while at the same time providing protection against market losses.

How Does an Equity Indexed Annuity Work?

Combining characteristics of both fixed and variable annuities, an equity indexed annuity allows the annuity holder to participate in the growth of the stock market, thus providing the potential of outperforming fixed income returns, while at the same time protecting the owner against the loss of principal and accumulated interest. As long as the annuity is owned to term and allowed to mature, protection is guaranteed. The term period is relatively short, typically between one and ten years.

An equity indexed annuity can be a very reasonable investment vehicle for those who find fixed income yields too low. However, equity index annuity holders are not subject to 100-percent guaranteed market returns, there is a cap on the interest rate credited to an annuity.

The annuity value is tied up to the performance of a stock market index, typically Standard and Poor's 500 Composite Stock Index, or linked to another index, such as the NASDAQ 100.  If the stock market rises, the annuity is credited with part of the gain in the index, not including the reinvestment of dividends. If the stock market declines, the annuity is credited with a guaranteed minimum return, usually 3 percent on 90 percent of the invested money.

Elements of Equity Indexed Annuities

  • Participation rate - determined by every insurer and subject to change, this is the percentage of increase in the stock index. Participation rates usually range from 30 to 100 percent of the stock index gains. If, for instance, the participation rate is 80 percent, and the stock index increases by 7 percent, the interest rate credited to an annuity will be 80% X 7% = 5.6%.
  • Indexing method - this is the method used by insurers to credit excess interest to annuities. When the annual reset method, also called the ratchet method, is used, the index value starting point is reset every year and interest earnings are calculated according to the yearly change in the stock index.
  • Maximum cap rate - the upper limit on the interest credited to an annuity. Not all annuities have a cap.
  • Guaranteed minimum value - it applies to equity indexed annuities with terms longer than one year. Guaranteed minimum value provides protection against any loss of earnings, as long as the annuity is held to term.
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