Equity-indexed annuities are complex insurance policies. These insurance policies promise the upside potential of stock market index returns, but without the risk of actually investing in the stock market. These insurance policies work by using a complex investing formula. If you want to invest in them, you should understand how to pick the best policies.
An index annuity works by investing your annuity savings into bonds. The insurer then takes the interest from those bonds and invests it into index call options. An index call option is the right, but not the obligation, to buy the value of the underlying stock market index at a preset price for a specific period of time. If the stock market increases in value within the time period specified in the contract, the insurer sells off the option contract and credits your annuity with the gains. The insurer is able to achieve the upside potential of the stock market because stock options use leverage. The option contract allows the insurer to control a large amount of the stock market without actually owning it and for a price that is much lower than a direct investment in the market. A precise mix of bonds and investment interest guarantee that you'll never lose money, while always leaving open the opportunity for gains derived from the stock market.
Index annuities sometimes use fees or spreads to control the amount of interest credited to the annuity. Insurers do this since they bear all of the risk if the stock option turns out to be unprofitable. The fee may be a flat fee or a percentage of the investment earnings that are credited to your annuity. The best annuities will limit or eliminate a fee altogether, letting you reap the maximum amount of gains in the contract.
Caps are used to limit earnings in the contract for the same reasons that fees are used. Caps limit earnings by placing a maximum interest rate ceiling on the interest credited to the annuity. For example, a cap of 10 percent means that the annuity will earn a maximum of 10 percent interest in any given year regardless of the actual market performance. If the stock market earns 7 percent, the annuity is credited with 7 percent. If the stock market earns 12 percent, however, the annuity is only credited with 10 percent. The insurer keeps the rest. The best annuities are the ones with the highest cap rates and a history of not lowering the cap rate.
A participation rate is another means of limiting growth in an indexed annuity. The participation rate limits the participation of the annuity's investments. So, a 75 percent participation rate means that the annuity will be credited with 75 percent of the market's performance. A 10 percent gain will be reduced to 7.5 percent. The best indexed annuities will normally give you a minimum guaranteed participation rate of 100 percent.
It's unavoidable to have insurers limit growth in your indexed annuity. However, high caps, a high participation and low fees are the ideal. Insurers may combine caps, fees and participation rates. Insurers also normally have the right to alter the rates over time. Keep things simple. An indexed annuity with the fewest "moving parts" (the least amount of ways to limit growth) often results in the highest investment potential for you.
- "Practicing Financial Planning for Professionals (Practitioners' Edition), 10th Edition"; Sid Mittra, Anandi P. Sahu and Robert A. Crane; 2007
- FINRA: Equity-Indexed Annuities---A Complex Choice
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