An equity-indexed annuity is a combination of a fixed and a variable annuity. Equity-indexed annuities give you the best of both worlds.
Guaranteed return: As with a fixed annuity, you get the low-risk appeal of a guaranteed minimum return (usually 2% to 3%).
With some upside: But, as with a variable annuity, you also have a shot at higher gains if the stock market rises, since an equity indexed annuity’s return is also tied to the performance of a benchmark index, such as the Standard & Poor’s 500.
A fixed index annuity is a deferred annuity that provides the opportunity to participating from the potential upside gains of the equities markets, while limiting the risk to possible market downturns by providing a contractually guaranteed minimum interest rate over the duration of the contract.
The interest rate paid on fixed index annuity varies more and is less predictable than that of a fixed income annuity, but offers the potential to share in the upside of the equities markets, thereby offering the opportunity for greater potential returns.
Although a fixed indexed annuity pays an interest rate that is tied to the performance of the equities markets, it is not a security and offers protection against any potential loss of principal that direct investment in the equities markets inherently entail.
A fixed index annuity may be right for you if you are looking for a way to participate in the potential upside gains of the equities markets without exposing your principal investment amount to any downside risk.
The trade-off of limiting the downside risk to principal is a cap or limit on the upside potential that is available, as compared to the underlying equities market. Insurance companies “cap” the potential upside interest rate that will be paid in a variety of ways, usually through one or more of the techniques listed below:
- Interest Rate Caps: Some index annuities contain a cap or upper limit on the amount of interest the annuity will earn. For example, if the cap rate is % and the index linked to the annuity gains 10%, only 8% interest will be credited to the annuity.
- Participation Rates: How much of the gain in the index will be credited to the indexed annuity? If, for example, an indexed annuity has an 75% participation rate, the annuity will be credited with only 75% of any gain experienced by the index.
- Spreads: An index annuity may contain a spread. If, for example, an index annuity has a 3% spread and the index gains 10%, the annuity would only be credited with 7% interest.
Understanding the differences between the crediting methods of various fixed index annuities is an important factor in determining which one may be most appropriate for your situation and objectives. Fixed index annuities often have a surrender charge period from between 3 – 16 years, within which if a policy owner withdraws more than 10% of his or her contract value in any one year they may be assessed a surrender charge or penalty on the amount they withdraw above the 10% amount. As with all deferred annuities, the policy owner may be assessed a 10% penalty tax by the IRS if they make any withdrawals from their annuity before their age 59 1/2. There are exceptions to this and potential investors should seek the guidance of their tax adviser for further clarification on this rule.
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