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Pecos Insurance Center

Pecos Insurance Center

Equity-Indexed Annuities

An annuity is a contract between an individual and an insurance company under which, in return for receiving a sum of money from the individual, the insurer agrees to pay a steady income to the annuitant—the person who is to benefit from the annuity. The annuitant may or may not be the owner—the person who enters into the contract and makes payments into the annuity.

Annuities can be broadly classed as fixed, which means earnings are guaranteed by the insurer, or variable, where there are no such guarantees because the annuity is invested in securities, subjecting the return to market fluctuations. Although riskier than a fixed annuity, variable annuities have the potential for greater returns that, theoretically at least, can keep pace with inflation.

An equity-indexed annuity (EIA) is a fixed annuity, but it has a feature that gives it, too, the potential for greater than guaranteed minimum returns. That feature is a link to a financial indicator or index, which may provide a greater return. Insurance companies structure EIAs in many different ways. Typical features are included here.

The most commonly used index is the S& P 500 (Standard and Poor’s 500), but others may be used. If the S&P 500 goes up, so will the earnings on the equity-indexed annuity. If it goes down, the EIA’s earnings will do likewise. But the drop is limited by a minimum guaranteed interest rate, typically about 3%. The actual earnings will be the greater of the guaranteed rate or the earnings generated by the index link.

Although the annuity’s earnings are linked to an index, an EIA is not considered a security because it is not actually invested in equity products. Like any other fixed annuity, the premiums are placed in the insurer’s general account.

The most popular annuities are those that are deferred; that is, the annuity will begin making income payments to the annuitant sometime in the future. A deferred annuity may be funded in one of two ways:

Single-premium deferred annuity requires the owner to fund the annuity with a single substantial payment. The actual amount depends on the amount of income desired in the future. This type of annuity is often purchased by someone who has received or accumulated a large sum of money, such as an inheritance, the death benefit from a life insurance policy, a bank CD that has matured, or a retirement plan distribution.

Flexible-premium deferred annuity allows the owner to make smaller periodic payments over the life of the annuity until such time as the annuitant will begin receiving income. Because the premium is flexible, the amount the owner pays may vary within limits established by the issuing insurer. Each premium payment may be increased or decreased if the owner’s circumstances so warrant. Of course, if a specific amount of income is desired, attention must be given to the amount of premium required to purchase that future income.

The EIA contract is written for a specific term over which the growth of the index is computed. If the annuity is kept intact during that term, the owner is guaranteed at least a return of the principal, regardless of how the index performs. The term can range from one to ten years, with four to seven years being the most common. At the end of that period, the annuity owner has several choices:

  • Renew the annuity for another term.
  • Make a tax-free exchange for another annuity, either fixed or variable.
  • Surrender the contract and receive its current value.
  • Annuitize the contract (begin to receive periodic payments).

During the term, the index value is noted on specific index dates for purposes of calculating earnings that will be credited to the EIA. The index dates are often anniversaries of the annuity’s effective date.

On the index dates, the insurer uses an indexing method to measure the change in the index. There are three popular methods:

  • Annual reset or ratcheting compares the index value at the beginning of the year with its value at the end of the same year.
  • Point-to-point is similar to annual reset except earnings are based on the difference between the index value at the beginning and the end of a longer period of time, such as the index term or a period of five years, at the insurer’s option.
  • High-water mark uses the difference between the index value at the start of the term and the highest value attained on an anniversary date during the term.

Earnings on the EIA may or may not be credited to the account immediately. If earnings are credited on the index dates, compounding of the interest occurs, providing a greater amount to accumulate in the annuity. Sometimes, however, earnings are not credited until the end of the term.

Any interest paid accumulates in the annuity along with the premium payments. Taxes are deferred on the interest during the accumulation period as long as the funds are not withdrawn.

Equity-indexed annuities include a contractual participation rate or index rate, which refers to a percentage of the index gain that will actually be credited to the annuity. This percentage can vary from about 60% to 100%, but rarely is it 100%. Here are some examples.

  • The participation rate stated in the contract is 60%. The index gain is 10%. The gain that will be credited to the EIA is 60% of 10%, or 6%.
  • The participation rate stated in the contract is 80%. The index gain is 5%. The gain that will be credited to the EIA is 80% of 5%, or 4%.

Other factors that affect equity-indexed annuities include these:

  • Insurers sometimes set a on the percentage increase allowed. For example, if the cap rate is 10% and the index has a 20% increase, no more than 10% would be permitted.
  • Insurers may average the index values daily, monthly or annually, and use the average as the basis for the increased index value.
  • The floor is another name for the minimum interest rate that is guaranteed to be credited to the annuity.
  • Some insurers offer a guaranteed death benefit in the event the annuitant dies before the annuity payments begin. The beneficiary will receive either the value of the contract on the date the annuitant dies or the total premiums paid into the contract, whichever is greater.

Because the most common purpose of an annuity is to accumulate retirement funds, an annuity should be considered a long-term proposition. To encourage owners to leave the annuity intact for a long period, insurers often assess a surrender charge if withdrawals are made early in the life of the annuity. After a specified period—possibly five years or more—the insurance company typically allows partial withdrawals of up to 10 or 15% annually of the total amount on deposit without charging a surrender fee.

If the annuitant makes a withdrawal before reaching age 59 1/2, the IRS levies a 10% penalty tax in addition to the regular income tax on the taxable portion of the withdrawal. This applies to both partial and complete withdrawals, but no tax penalty is assessed under these limited circumstances:

  • The owner/annuitant dies;
  • The owner/annuitant becomes disabled; or
  • The withdrawal is paid out as part of a series of substantially equal periodic payments made for the life or life expectancy of the owner/annuitant, or for the joint lives or life expectancies of the owner/annuitant and a beneficiary.

When the time comes for the annuitant to begin receiving income from the annuity, a number of options are available for how the income will be paid. These settlement options further define the annuity. They are:

  • Straight-life or life-only annuity. Payments cease when the annuitant dies, even if the entire investment in the annuity has not been paid out. This option is rarely selected since most people want to recoup the entire amount by leaving it to a beneficiary if the annuitant dies early.
  • Joint-life annuity. Typically there are two annuitants (although there may be more) and payments stop when either one dies. This option is used in cases where additional income is required for two people, but the single survivor does not require the additional income.
  • Joint-and-last-survivor annuity.Annuity payments are made until the death of the last annuitant. Sometimes, a reduced payment (often one-third or one-half) is made after the first annuitant dies, reflecting a smaller income need to support the second person.
  • Period-certain annuity. Income will be paid for a specified period of time until funds are exhausted. The amount of each payment is determined by the length of the period and the amount available in the annuity at the beginning of the payout.
  • Amount-certain annuity. A specified amount will be paid regularly to the annuitant. The length of time that amount will be paid depends on the amount available in the annuity at the start and the amount of each payment.
  • Refund annuity. Offered in different forms, these forms are alike in that if the annuitant dies before fully receiving the income, the insurer will provide either a continuation of the income or a lump-sum settlement to a named beneficiary.

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