What is an Index Equity Annuity

There are annuities that provide a fixed rate of return where your principal investment will be held steady. This is called a fixed annuity.  Rates are usually very low but the risk of principal loss is not a factor with these annuities.  Another type of annuity is one where the principal does fluctuate with the stock market movements.  This is called a variable annuity.  Variable annuities are invested in mutual funds which are in turn invested in stocks and bonds and will move up and down with the markets. An Index Equity Annuity is a combination of a fixed annuity and a variable annuity. 

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How an Index Equity Annuity Works

With an Index Equity annuity your principal investment is guaranteed not to go down if the stock market goes down.  You are guaranteed a minimum fixed rate of return on your money.  This rate will be lower than the guaranteed rate on a fixed annuity because it is designed to let you participate with the upside movement in the stock market.  For this opportunity you will get a very low guaranteed interest rate.  Some of the current Index Equity annuities can even pay zero percent interest, although most will have some nominal interest credit.

An example of an Index Equity annuity might be one that will pay a minimum rate of 1% with an upside limit of 8%.  If the Index that the annuity is based on, like the S & P 500 index for instance goes up 12% for the year, you would be credited with an 8% increase in the value of your annuity.  If the S & P 500 index increased 35% for the year you would still see an 8% increase in the value of your contract.

If however, the S & P 500 index decreased by 20% for the year, your principal would not go down and you would receive a 1% increase on the value of your contract.  So, in a way you are getting the best of both worlds, just without some of the risk.  You obviously give up some of the potential to have this benefit of limited risk though. 

Who Should Consider Investing in an Index Equity Annuity

The type of person who should consider an Index Equity annuity is someone who is risk averse when it comes to the principal invested, but who is willing to give up almost all returns for the opportunity to gain a higher return on their principal.  In other words they are somewhat adventuresome but only with the returns they may or may not receive.  They want to maintain stability of their principal.

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Can a Person Lose Money with an Index Equity Annuity

Yes.  The return of principal and the guaranteed interest rate is based upon the credit worthiness and financial soundness of the annuity issuer.  This is typically an insurance company.  Usually insurance companies do not fail but never say never; especially in our current economic environment.  You should make sure that you check the credit rating of the company you are investing with before you purchase an annuity.  Fixed and Index Equity annuities are tied directly to the companies who issue them.  Variable annuities are invested in many different mutual funds, so they are a bit more diversified. 

Another way you can lose money with an Index Equity annuity is if you take your money out of the annuity before the surrender charge period has passed.  If you purchase an annuity with a guaranteed minimum rate of 1% but it has a surrender charge of 7% in the first year that decreases by 1% a year until after the seventh year you may lose money if you come out of the annuity during those first seven years.

For example, suppose you invest $100,000 and the market has gone down in the first two years and you decide to come out at the end of the second year.  You will receive 100,000 + 1000 (first years minimum) + 1000 (second years minimum) – 5000 (early surrender charge) = $97,000 total.  This is a simplified example but you see that you can lose money in this situation.  If you purchase any type of annuity it is best to hold them until the surrender period is over. 

An Example of the Benefits of an Index Equity Annuity

Here is an example to show the benefits of an Equity Indexed annuity.  Suppose you purchase this type of annuity with a $100,000 investment.  In the first three years the market goes down so you have to settle for a 1% annual increase in your account value, at the end of the third year your value is $103,000. (this is assuming straight interest and no compounding) Then in the 4th year the stock market takes off and we have a 20% gain for the year.  If you participate up to 8% like in our previous example you get an increase of 8% in that year.  So for the four years your average return is 3% and you have no major downside risk.

Over a period of years you are more likely than not to gain an above average rate of return while being able to sleep at night because your principal is not affected by potential 1000 point declines in the stock market in one day. You are giving up the potential of extreme upside in the market over a long period of time, but you don’t have as much stress in the rough times.

Conclusion

In conclusion, you can see that this type of annuity is kind of the middle ground between the more aggressive variable annuity and the low risk, low return fixed annuity.  Parts of each are included in the indexed annuity.  There are more costs associated with this type of annuity than you would have with a simple fixed annuity, however, if you have some time before you retire, you can usually do better with more the higher level of opportunity that this type of annuity offers.

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