Basics of Equity Indexed Annuities

If you have been planning to buy an annuity, and you have bullish opinions about the way the stock market is going to be priced between now and the time you begin to receive your annuity payments, you may want to consider equity indexed annuities.

How Equity Indexed Annuities Work

The equity indexed annuity is a simple concept. The annuity is linked to a stock market index like the S&P 500. If the price of the S&P 500 rises over time, interest rates will rise in line with it. If the price falls, there will usually be a guaranteed minimum annuity payment which will not be reduced even if the market lowers below what it was when you paid your annuity premiums.

Advantages

-The linking of an annuity’s interest to a specific stock index is the main reason for purchasing the annuity. If the stock market rises rapidly, your annuity will also see high gains. Bullish markets mean bullish returns on equity indexed annuities.

-Linking the interest rate of the annuity to the stock market means that real goods and their associated market prices are the basis for the annuity rate. If inflation rises, the stock market will also rise, meaning that your future annuity payments are hedged against the risk of inflation.

Disadvantages

-Can offer little to no growth in times of slow market growth. If the market fails to grow or has a negative return, you may see no increased return on your payment, which means you will actually lose your money to inflation over time.

-Can be confusing for people with little knowledge about the stock market and its potential for growth. Be sure to inform yourself on the potential of various indexes out there and make a decision for yourself or get advice from an expert financial planner on which index to associate your annuity with.

Caps

As mentioned above, there is usually a guaranteed minimum annuity payment even if the market dives below what you paid premiums into the annuity for. In order to ensure that the insurance company doesn’t only experience the negative side of risk, but also gets the positive side, they often put a cap on the interest that can be earned per year.

For example, if the S&P 500 grows by 15% in a year, but there is a cap of 10%, then the future annuity payment will only have grown by 10% and the insurance company will pocket the other 5%.

Caps are an important factor to consider when purchasing an annuity, because they limit the maximum amount of growth you may see in your annuity. If you can get a guaranteed fixed annuity for 7%, and there is a capped equity indexed annuity available for 8%, it may make more sense to buy the fixed annuity since it has no risk and the equity indexed annuity would offer little return (an extra 1%) in exchange for greater risk.

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