Equity Indexed Annuities

As promised, we are now going to discuss equity indexed annuities in more detail.

Recognition of Interest

The amount of interest an equity indexed annuity earns primarily depends on how well the tracked index performs during the year. Obviously the equity index has to show a gain in order for the annuity to earn money, but how and when earnings are credited to an annuity account is also very important.

Basically indexed annuity earnings are calculated by the annuity's indexing formula and by interest recognition periods.

Indexing Formula

The annuity's indexing fromula determines how much interest the annuity can earn based on the performance of the equity index.

So let's say so far this year, the S&P 500 index has shown a net increase of 15%. In theory, 15% interest would then be credited to the equity indexed annuity.

However, in the real world, insurance companies will limit gains paid to equity indexed annuities in order to protect themselves from possible losses. Remember that one of the good things about equity indexed annuities is the investor will not be credited with losses when the index loses money.

So to limit the amount of gains paid to annuities, equity indexing fromulas use interest ceiling and participation rates.

Interest Cap

Most indexed annuities have an interest ceiling or cap, which limits the maximum amount of interest earned.

For example, if the S&P 500 has a really good year and makes 15%, but the cap in your annuity is 12%, than your account would be credited with 12% interest.

If you have trouble understanding how this works you can think of it this way, the insurance company pays you only a portion of its earnings from the stock market in order to offset its losses when the market goes down. So even though your annuity doesn't share in all of the gain, you don't have to absorb any of the stock market losses.

Participation Rate

Closely related to interest ceiling is another limiting factor called the participation rate. This is the percentage of the gain you are actually eligible for before the ceiling limit is applied. So the formula would be Gain % x participation rate %, not to exceed the ceiling amount.

For example, say you have a 90% participation rate and the S&P 500 had a 15% gain so your annuity would be eligible for 13.5% gain subject to the ceiling limit. If the annuity cap was 12%, then you would get 12% interest for the year.

So if you want to maximize gain in your equity indexed annuity, you are looking for a high participation percentage and a high ceiling cap. However be aware that you may have to accept a lower floor or even participate in losses to maximize your gain. Remember it's all a balancing act between the insurance company's profits resulting from investing in the equity index and its ability to pay those profits into the equity indexed annuity.

Interest Recognition Periods

Let's continue to use the above example. You earned 12% for the year, so you would expect to see 12% of your funds value credited to your account. However, your account may be credited only once a year with all your earnings or it might be credited more frequentley.

Obviously those indexed annuities that credit interest to your account several times a year are more advantageous because the interest will compound more often.

So as an investor, you are looking for a high cap rate, a high participation rate, and frequent interest crediting to your annuity.

Next we will talk about income tax effects on annuities.

Income Taxes and Annuities >>

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