Equity-indexed Annuity - A Different Way To Credit Interest

A Different Way To Credit Interest

The indexed annuity is virtually identical to a fixed annuity except in the way interest is calculated. As an example, consider a $100,000 fixed annuity that credits a 4% annual effective interest rate. The owner receives an interest credit of $4,000. However, in an equity-indexed annuity, the interest credit is linked to the equity markets. For example: Assume the index is the S&P 500, a one-year point-to-point method is used, and the annuity has an 8% cap. The $100,000 annuity could credit anything between 0% and 8% based on the change in the S&P 500. The cap, 8% in this example, is determined by how much is afforded by budget which is usually at or near the 4% fixed rate. If fixed rates increase, it would be expected that the cap would increase as well.

This allows the owner the security of knowing that the $100,000 is safe but rather than receiving the sure 4% they can receive up to 8%. Historically since 1950, an 8% cap on the S&P 500 has resulted in an average interest credit of 5.2%, very similar to what is considered the "risk free rate of return" delivered by T-bills, 5.1% over a similar period. The return may also be adjusted by other factors such as the participation rate and market value adjustments to cover bring the cost of the option into the budget available.

This means the owner of the indexed annuity now has assumed more risk than a fixed annuity but less than being in the equity markets themselves. The result is that the expected yield (risk adjusted) for an indexed annuity is higher than a fixed annuity, CD, etc. However, the expected yield of being in the market is higher for several reasons.

The principal (in our example the $100,000) is at risk of loss when owning the index outright. Equity Index Annuity does not participate in dividends as owning the index outright would and similar there are no ongoing transaction expenses or fees. Interest is compounded as frequently as when interest is credited and this is almost always annually but contracts are available that credit interest over a 5 year term.

The taxation of the gains in an indexed annuity is identical to that of fixed annuities. Taxes are deferred until monies are received and then interest is withdrawn first and taxed as ordinary income. If the index was owned outright, gains would not be tax deferred, but may qualify for the more favorable capital gains tax rate.