Course 401: Variable Annuities
Equity-Indexed Annuity
In this course
1 Introduction
2 What's a Variable Annuity?
3 Fixed Immediate Annuity
4 Fixed Deferred Annuity
5 Variable Annuity
6 Equity-Indexed Annuity

Pros

  • Equity-indexed annuities give holders equity participation as well as some safeguards if the stock market performs poorly.
  • Offers tax-deferred growth.

Cons

  • In a strong up market, investors in these vehicles will see their gains muted.
  • These vehicles are also complicated and can carry significant surrender charges, as well as a tax penalty if you need to sell before age 59 1/2.
  • Withdrawals are taxed as ordinary income.

These vehicles, often pitched as a happy medium between fixed and variable annuities, have exploded in popularity during the past several years. Although there are many different variations, the basic idea is the same: Equity-indexed annuities typically promise some guaranteed rate of return, much like a fixed annuity, but they also offer participation in equity market returns.

Under a typical scenario, an equity-indexed annuity will offer a minimum return that amounts to 90% of the premium paid at a 3% interest rate. In an up market, it will also offer a percentage of the return of a stock market index, usually the S&P 500. Some equity-indexed annuities cap the equity gains you're eligible to receive.

As with the other annuities, earnings in equity-indexed annuities increase on a tax-deferred basis, and holders pay income tax on their distributions. Equity-indexed annuities also typically include a death benefit. Additionally, when stocks were going up, critics bemoaned that owners of equity-indexed annuities would receive only a fraction of the stock market's gains. But as the stock market tanked from 2007 through early 2009, owners of these annuities were able to limit their stock market-related losses.

Still, there are a couple of persistent issues with equity-indexed annuities. The first is that they're complicated. Insurers use different methods of calculating the index return that holders pocket, and you need to read the fine print to determine how your own return will be calculated. Moreover, equity-indexed annuities don't typically include reinvested dividends when calculating index returns, yet dividends have historically accounted for nearly 40% of the market's total return. Finally, equity-indexed annuities often carry steep surrender charges, though some insurers waive them for medical reasons or other emergency expenses.

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