What Is an Equity Indexed Annuity?

An equity indexed annuity is simply a dated name for a fixed indexed annuity. Fixed index annuities came about in the mid-1990s.

They were intended as an option for retirement savers looking for alternatives to low-interest CDs and low-paying fixed-interest instruments, such as Treasury securities.

How the “Equity Indexed Annuity” Came About

Life insurance companies used different names in marketing fixed indexed annuities to the public. Since they are fixed insurance contracts and therefore under the authority of state insurance commissioners, the term “equity indexed annuity” eventually went out of vogue.

It made people think that a fixed index annuity was a securities product. However, it still remains a fixed insurance product regulated by the states to this day. There is no “equity” component at all to a fixed index annuity.

Cutting Through the Confusion

Annuity market researcher Sheryl Moore talks about how calling fixed indexed annuities “equity indexed annuities” had gone out of style by the 2010s.

In articles like this one, she chastises the financial media for still referring to them as equity indexed annuities. After all, that adds to public confusion.

While insurance companies have created new fixed index annuity products for consumer needs, their premise still remains the same.

More on How a Fixed Index Annuity (‘Equity Indexed Annuity’) Works

A fixed index annuity, or equity indexed annuity as mentioned before, earns interest based on an underlying financial benchmark index.

Over three-quarters of fixed indexed annuity contracts started by annuity owners have the S&P 500 price index as their benchmark. But new index options have also started being offered to retirement savers.

Many contracts now offer other benchmark indexes that focus on core financial sectors, like commercial real estate or healthcare. Some indices focus on the United States while others are global or region-focused elsewhere, such as Europe or Asia.

How This Type of Annuity Earns Interest

When this underlying index goes up, a portion of that growth is credited to the annuity owner’s contract value. The contract value is another name for the money inside the annuity. This growth is shown as a percentage rate.

When the index goes down, the insurance company simply credits zero interest to the contract value for that period. The principal and credited growth from prior times will stay intact.

In exchange for this protection against index loss situations, insurance companies limit the growth potential of fixed index annuities with caps, participation rates, and spreads.

What Is the Growth Potential of a Fixed Index Annuity Like?

Fixed index annuities are designed to earn interest greater than a CD, a traditional fixed annuity, or other fixed-interest assets can pay.

While it can earn double-digit interest for a period, this isn’t typical. A retirement saver shouldn’t have these growth expectations entering into the contract.

Speaking from history, it’s not unheard of for a fixed index annuity to have average growth in the range of 2% – 7%, but again this isn’t guaranteed at all.

Different Options for Earning Interest

Fixed indexed annuities usually have several options that you can choose for your annuity to earn interest. You don’t have to put all of your money into one of these buckets, as you can allocate it among more than one.

These options are called “crediting strategies.” There are many crediting strategies in the fixed index annuity product marketplace today. For example, some crediting strategies work on a framework called one-year point-to-point.

More on Fixed Index Annuity Crediting Strategies

In this case, the value of the benchmark index is compared from the beginning of the year to the end. The contract anniversary date is used as the end point, and the starting date for that period is the beginning point.

If you purchase a fixed index annuity on June 12, then the contract will compare the value of the benchmark index from June 12 of last year to June 12 of the next year. Say the index was at 2,000 on June 12 of last year, and then rose to 2,200 on June of the next year.

That would be a 10% index gain, and depending on how the crediting strategy works, your annuity would earn interest that is based on a portion of that growth.

Other crediting strategies are based on two-year point-to-point. Other strategies run on a monthly or quarterly basis. Some even use daily index averages in their interest-earning calculations.

Longer crediting strategies generally earn more interest, but you will have to wait longer to see the growth, if any, credited to your annuity. It’s always a question of balance and what you are willing to do.

Interest credits will only be added using this strategy on the contract anniversary date. Once added, interest credits will be “locked in” and won’t be affected by what the index might do in the future.

Many Crediting Strategies Available Today

There are several other crediting methods available in the marketplace. This is where the caps, participation rates, and spreads can come into play.

Consult your financial advisor or life insurance agent for more information on these crediting strategies and methods. They can go over the pros and cons of different options with you.

Other Annuity Features to Keep in Mind

Like all other types of annuities, fixed index annuities can pay out a guaranteed stream of income that someone can’t outlive.

The annuity owner will continue to receive this income, even if all of the value in the contract is depleted. This is one of the chief advantages of annuities.

Another key advantage of annuities is their built-in tax advantage for growth. The money inside annuities grows tax-deferred without having to be placed into an IRA or other tax-advantaged retirement plan.

You can’t take a deduction for your annuity premium unless it is being placed in an IRA or IRS tax-advantaged retirement plan (purchases only, not rollovers).

However, you can some leeway on how much money you can put into a non-qualified annuity contract. Most life insurers have in-house limits on how much they will accept for annuity premium, so that is also good to remember.

Tax Treatment of Annuities

The money that you draw out of an annuity is taxed as ordinary income. There is no capital gains treatment with annuities of any type.

That being said, some tax-planning strategies are available with annuities that are non-qualified contracts or are housed inside Roth IRAs.

Consulting with the Right Financial Professional

Your financial professional can provide more information on those options, and more details on fixed index annuities in general and how they might help you.

Don’t be afraid to ask questions about what you don’t understand and make sure that you are comfortable before moving forward with a decision. You have worked hard for your life savings. You should be comfortable about any financial strategy that is recommended to you.

What if you are looking for a financial professional to guide you in this and other retirement “what-ifs?” For your convenience, many independent and experienced financial professionals are available at SafeMoney.com.

Use our “Find a Financial Professional” section to connect with someone directly. You can request an initial appointment to discuss your needs, goals, and situation. Should you need a personal referral, call us at 877.476.9723.

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