Equity-Indexed Annuities

Equity-indexed annuities (EIAs), also known as "fixed-indexed insurance products" and "indexed annuities" are very confusing and complex products. EIAs are annuities that typically calculate the gain to the investor based upon an index the annuity is linked with. However, there are several different indexing methods used and because of the variety and complexity of the methods used to credit interest it is often difficult to compare one EIA to another.

Securities annuities come in two types: fixed and variable. A fixed annuity guarantees a rate of return and the payout. A variable annuity's rate of return varies with the performance of the stocks, bonds, and investment options selected. Investors may earn no return on the investment and there is a risk of loss. Unlike fixed annuities, variable annuities are registered securities.

EIAs have characteristics of both fixed and variable annuities. An EIAs return varies more than a fixed annuity, but not as greatly as a variable annuity. EIAs offer both a minimum guaranteed interest rate combined with an interest rate determined by a securities market index. Typically, the guaranteed minimum return is at least 87.5 percent of the premium paid at 1 to 3 percent interest.

The index-linked gain depends on the indexing features that the EIA uses. The most common indexing features are participation rates, spread/margin/asset fee, and interest rate caps. A participation rate determines the amount of the index gain will be credited to the annuity. The annuity may set the participation rate at 80 percent limiting the investor’s index credit to 80 percent of the index gain. EIAs can also use a spread, margin, or asset fee in addition to or instead of a participation rate and will subtract this percentage from any index gain. Finally, some EIAs may place a cap or upper limit on the return as a stated percentage. In addition, some EIAs are allowed to change the participation rates, cap rates, or spread/asset/margin fees either annually or at the next contract term.

There are also several methods for EIAs to determine the change in the relevant index over the period of the annuity including the annual reset, high water mark, and point-to-point. The annual reset compares the change in the index from the beginning to the end of each year and interim declines are ignored. The high water mark takes the index value at various points during the contract, most commonly on annual anniversaries. The method then takes the highest of these values as compared to the index level at the start of the term. The point-to-point method compares changes in the market index at two discrete points in time, many times the beginning and ending dates of the contract term.

EIAs are also long-term investments and most EIAs have early surrender charges if the customer withdraws funds. The surrender charge is often a percentage of the amount withdrawn or a reduction in the interest rate credited to the EIA. Withdrawals from a tax-deferred annuity before the customer reaches age of 59½ may be subject to a 10 percent tax penalty in addition to any gain being taxed as ordinary income.