What is an Equity Indexed Annuity

Learn about Equity Indexed Annuities
If you are considering buying or purchasing an equity-indexed annuity, this will explain what equity-indexed annuities are and provide resources for obtaining additional information. It provides a good understanding for thebeginner and a basic review for the more experienced investors.

What is an equity-indexed annuity?

An equity-indexed annuity is a special type of contract between you and an insurance company. During the annuity accumulation period, when you make either a lump sum payment or a series of payments, the insurance company credits you with a return that is based on changes in an equity index, such as the S&P 500 Composite Stock Price Index. The insurance company typically guarantees a minimum return. Guaranteed minimum return rates vary. After the accumulation period, the insurance company will make periodic payments to you under the terms of your contract, unless you choose to receive your contract value in a lump sum.

Can you lose money buying an equity-indexed annuity?

You can lose money buying an equity-indexed annuity, especially if you need to cancel your annuity early. Even with a guarantee, you can still lose money if your guarantee is based on an amount that’s less than the full amount of your purchase payments. In many cases, it will take several years for an equity-index annuity’s minimum guarantee to “break even.”
You also may have to pay a significant surrender charge and tax penalties if you cancel early. In addition, in some cases, insurance companies may not credit you with index-linked interest if you do not hold your contract to maturity.

What are some of the contract features of equity-indexed annuities?

Equity indexed annuities are complicated products that may contain several features that can affect your return. You should fully understand how an equity-indexed annuity computes its index-linked interest rate before you buy. An insurance company may credit you with a lower return than the actual index’s gain.

Some common features used to compute an equity-indexed annuity’s interest rate and return include:
Participation Rates. The participation rate determines how much of the index’s increase will be used to compute the index-linked interest rate. For example, if the participation rate is 80% and the index increases 9%, the return credited to your annuity would be 7.2% (9% x 80% = 7.2%).Interest Rate Caps. Some equity-indexed annuities set a maximum rate of interest that the equity-indexed annuity can earn. If a contract has an upper limit, or cap, of 7% and the index linked to the annuity gained 7.2%, only 7% would be credited to the annuity.Margin/Spread/Administrative Fee. The index-linked interest for some annuities is determined by subtracting a percentage from any gain in the index. This fee is sometimes called the “margin,” “spread,” or “administrative fee.” In the case of an annuity with a “spread” of 3%, if the index gained 9%, the return credited to the annuity would be 6% (9% - 3% = 6%)
Another feature that can have a dramatic impact on an equity-indexed annuity’s return is its indexing method (or how the amount of change in the relevant index is determined).
Some common indexing methods include:
Annual Reset (or Ratchet). This method credits index-linked interest based on any increase in index value from the beginning to the end of the year.Point-to-Point. This method credits index-linked interest based on any increase in index value from the beginning to the end of the contract’s term.High Water Mark. This method credits index-linked interest based on any increase in index value from the index level at the beginning of the contract’s term to the highest index value at various points during the contract’s term, often annual anniversaries of when you purchased the annuity.
Before you decide to buy or purchase an equity-indexed annuity, you should understand how each feature works and what impact, it may have on the annuity’s potential return.
Are equity-indexed annuities registered with the Securities and Exchange Commission?
Equity-indexed annuities combine features of traditional insurance products (guaranteed minimum return) and traditional securities (return linked to equity markets). Depending on the mix of features, an equity-indexed annuity may or may not be a security. The typical equity-indexed annuity is not registered with the SEC.


Glossary of Retirement Planning Terms

401(k) Plan: In this type of defined contribution plan, the employee can make contributions from his or her paycheck before taxes are taken out. The contributions go into a 401(k) account, with the employee often choosing the investments based on options provided under the plan. In some plans, the employer also makes contributions, matching the employee's contributions up to a certain percentage. SIMPLE and Safe Harbor 401(k) plans have additional employer contribution and vesting requirements.

• Retirement Planning

Benefit Accrual: The amount of benefits accumulated under the plan.

Cash Balance Plan: A type of defined benefit plan that includes some elements that are similar to a defined contribution plan because the benefit amount is computed based on a formula using contribution and earning credits, and each participant has a hypothetical account. Cash balance plans are more likely than traditional defined benefit plans to make lump sum distributions. (For more information, see Frequently Asked Questions about Cash Balance Pension Plans on the Department of Labor's Web site, at www.dol.gov/ebsa/faqs/.)
Defined Benefit Plan: This type of plan, also known as the traditional pension plan, promises the participant a specified monthly benefit at retirement. Often, the benefit is based on factors such as your salary, your age, and the number of years you worked for the employer.

Defined Contribution Plan: In a defined contribution plan, the employee and/or the employer contribute to the employee's individual account under the plan. The employee often decides how their accounts are invested. The amount in the account at distribution includes the contributions and investment gains or losses, minus any investment and administrative fees. The contributions and earnings are not taxed until distribution. The value of the account will change based on the value and performance of the investments.

Employee Retirement Income Security Act of 1974 (ERISA): A Federal law that sets standards of protection for individuals in most voluntarily established, private-sector retirement plans. ERISA requires plans to provide participants with plan information, including important facts about plan features and funding; sets minimum standards for participation, vesting, benefit accrual, and funding; provides fiduciary responsibilities for those who manage and control plan assets; requires plans to establish a claims and appeals process for participants to get benefits from their plans; gives participants the right to sue for benefits and breaches of fiduciary duty; and, if a defined benefit plan is terminated, guarantees payment of certain benefits through a federally chartered corporation, known as the Pension Benefit Guaranty Corporation (PBGC).

More Retirement Planning Terms:

Employee Stock Ownership Plan (ESOP): A type of defined contribution plan that is invested primarily in employer stock.
Individual Benefit Statement: An individual benefit statement provides information about a participant's retirement benefits, such as the total plan benefits earned and vested benefits, on a periodic basis. Additional information may be included depending upon the type of plan, such as how a 401(k) plan account is invested.
Individual Retirement Account (IRA) An individual account set up with a financial institution, such as a bank or a mutual fund company. Under Federal law, individuals may set aside personal savings up to a certain amount, and the investments grow, tax deferred. In addition, defined contribution plan participants can transfer money from an employer retirement plan to an IRA when leaving an employer. IRAs also can be part of an employer plan.
Money Purchase Plan: A money purchase plan requires set annual contributions from the employer to individual accounts and is subject to other rules.

Multiemployer Plan: A retirement plan sponsored by several employers under collective bargaining agreements that meets certain other requirements. A participant who changes jobs from one sponsoring employer to another stays within the same plan.

Plan Administrator: The person who is identified in the plan document as having responsibility for running the plan. It could be the employer, a committee of employees, a company executive, or someone hired for that purpose.
Plan Document: A written instrument under which the plan is established and operated.

Plan Fiduciary: Anyone who exercises discretionary authority or discretionary control over management or administration of the plan, exercises any authority or control over management or disposition of plan assets, or gives investment advice for a fee or other compensation with respect to assets of the plan.

Plan Trustee: Someone who has the exclusive authority and discretion to manage and control the assets of the plan. The trustee can be subject to the direction of a named fiduciary and the named fiduciary can appoint one or more investment managers for the plan's assets.

Plan Year: A 12-month period designated by a retirement plan for calculating vesting and distribution, among other things. The plan year can be the calendar year or an alternative period, e.g., July 1 to June 30.
Profit-Sharing Plan: A profit-sharing plan allows the employer each year to determine how much to contribute to the plan (out of profits or otherwise) in cash or employer stock. The plan contains a formula for allocating the annual contribution among the participants.

Rollover: A rollover occurs when a participant leaves an employer and directs the defined contribution plan to transfer the money in his account to a new plan or individual retirement account. This preserves the benefits and does not trigger any tax consequences if done in a timely manner .

Safe Harbor 401(k): A safe harbor 401(k) is similar to a traditional 401(k) plan, but the employer is required to make contributions for each employee. The employer contributions in Safe Harbor 401(k) plans are immediately 100 percent vested. The Safe Harbor 401(k) eases administrative burdens on employers by eliminating some of the complex tax rules ordinarily applied to traditional 401(k) plans.

Savings Incentive Match Plan for Employees of Small Employers (SIMPLE): A plan in which a small business with 100 or fewer employees can offer retirement benefits through employee salary reductions and matching contributions (similar to those found in a 401(k) plan). It can be either a SIMPLE IRA or a SIMPLE 401(k). SIMPLE IRA plans impose few administrative burdens on employers because IRAs are owned by the employees and the bank or financial institution receiving the funds does most of the paperwork. While each has some different features, including contribution limits and the availability of loans, required employer contributions are immediately 100 percent vested in both.

Simplified Employee Pension Plan (SEP): A plan in which the employer makes contributions on a tax-favored basis to individual retirement accounts (IRAs) owned by the employees. If certain conditions are met, the employer is not subject to the reporting and disclosure requirements of most retirement plans. Under a SEP, an IRA is set up by or for an employee to accept the employer's contributions.

Summary Plan Description: A document provided by the plan administrator that includes a plain language description of important features of the plan, e.g., when employees begin to participate in the plan, how service and benefits are calculated, when benefits become vested, when payment is received and in what form, and how to file a claim for benefits. Participants must be informed of material changes either through a revised Summary Plan Description or in a separate document called a Summary of Material Modifications.

Vested Benefits: Those benefits that the individual has earned a right to receive and that cannot be forfeited.
Years of Service: The time an individual has worked in a job covered by the plan. It is used to determine when an individual can participate and vest and how they can accrue benefits in the plan.