Equity-indexed annuities (EIAs) are an alternative investment to a traditional fixed rate or variable rate annuity, and is far more likely to appeal to more moderately conservative investors. Equity-indexed annuities are set apart from other indexed annuities by the interest yield return being partially based on an equities index, like the S&P 500 index.
One key feature of this type of annuity is the participation rate, which limits the extent to which the annuity owner participates in market gains. For example, if the annuity has an 80 percent participation rate, and the index it is linked with shows a 15 percent profit, the annuity owner participates in 80 percent of that profit, realizing a 12 percent profit.
There are benefits for accepting limited profits. The investor will receive protection against downside risk, and is usually guaranteed to at least break even each year that interest is earned in terms of the equity index portion of earned interest. Some equity-annuities also feature an absolute cap on total interest that can be earned, while others will or will not compound interest.
Interest payments are calculated from the changes in the equity index level. These changes are calculated by equity annuities using one of three calculation formulas:
- Annual Reset Formula – This is the most common formula. It looks only at the index gains and completely ignores declines. This can offer the investor a substantial benefit if there is a down turn in the stock market.
- Point-to-Point Method – This formula averages the index-linked return from the index gains at two separate points during the year.
- High-Water Mark – This formula looks at the index values at each anniversary date of the annuity, then selects the highest index value from those. This is averaged with whatever the index value was at the beginning of the payment term.
There are many different factors that can significantly affect your equity-indexed annuities’ potential profitability. Some analysts even question if this type of annuity can be considered a good investment at all. However, the general appeal of equity-indexed annuities is certainly to the moderately conservative investor who enjoys some opportunity to earn a higher investment return than what is available from traditional fixed-rate annuities, as well as still having some protection against a downturn market. If you want to take some risk, but still want a fair amount of protection, an equity-indexed annuity could be the option for you.