Equity Linked Annuities

If you’re considering investing in an annuity but you can’t decide between a fixed rate annuity or a variable annuity, you may be a candidate for an equity linked annuity.  Most people know this annuities by the name Equity Indexed annuities.  Equity linked annuities can be more easily understood if we first start by explaining what an annuity is and why someone would want to have one.

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What is an Annuity

An annuity is a contract between the purchaser, you for example and an insurance company.  You make a lump sum deposit with the insurance company or periodic payments in return for a promise by the insurance company to pay you regular monthly or yearly payments for the rest of your life starting now or at some point in the future. 

If the payments are starting now, this is an immediate annuity.  If the payments will not start for several years, if is called a deferred annuity.  The income taxes on gains made while investing with a deferred annuity are deferred until the time you start taking withdrawals. This allows the account to grow much faster currently. 

Fixed Annuities

Annuities can be fixed which means that they are invested in instruments that give them a guaranteed return of a certain interest rate for a set time frame.  These interest rates will be reset periodically however; the account value does not go up and down with the stock market.  The only principal risk with a fixed annuity is the insurance company’s ability to return the principal and interest in the future.

Variable Annuities

Variable annuities are invested in mutual funds that have exposure to the stock and bond markets.  Their values fluctuate up and down with the market value of the stocks they are invested in.  If the market does well, your account value will increase.  If it does not so well you will lose money. 

How Equity Linked Annuities fit into the Mix Between Fixed and Variable

Equity linked annuities or Equity Indexed annuities have some of the benefits of both fixed and variable annuities.  They are like fixed annuities in that they guarantee a minimum return of a certain percent.  This minimum return is typically lower than what a fixed annuity might pay.  The benefit of the equity linked annuity is that it is linked to one of the stock market indexes like the S & P 500.  If the S & P 500 goes up, your account will receive a higher rate of return.

When you first purchase your Indexed annuity you will know what the relationship to the index is.  For example, your contract may state that you will participate at 80% of the index.  If the index goes up 10%, you will get an 8% return.  If it goes down you may get a minimum return of 2%. 

There is usually a cap beyond which you will not participate.  An example is 8%.  If the index goes up 15%, you would think that you would receive 12%, however if your contract has an 8% cap, then you will only get 8%.  If the index goes up 8% you will get 6.4% and so on. 

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Can You Lose Money with an Equity Linked Annuity

Yes.  You can potentially lose money with an equity linked annuity.  If the insurance company goes bankrupt you can lose money.  If you take your money out before the surrender period is over you can also lose money.  Some insurance companies only guarantee the return of 90% of your initial deposit also.  After considering the minimum guaranteed interest rate you could potential lose some money with this type of annuity. 

Equity Linked annuities are not completely risk free, however your principal will be more secure with an Indexed annuity than with a variable annuity.  However, a fixed annuity would keep your principal safer than an equity indexed annuity.  These are fairly complicated annuities.  If you are not sure of what you are buying you should speak to someone who is experienced in this area.  There are a lot of variables that you must agree to with this type of contract.  Make sure you understand them all before you buy.

How are Interest Rates Credited

Interest in Equity Linked Annuities may be credited using the annual reset or Ratchet method.  This means that the interest is based on any increase in the index value from the beginning of the year to the end of the year.  Point –to-Point interest crediting is based on any increase from the beginning to the end of the contracts term.  High-Water-Mark interest crediting is based on any increase in the index value from at the beginning of the contract to the highest index value to a certain point like the anniversary date.

As stated earlier these are complicated contracts so make sure that you understand every aspect of the annuity before you invest.  You may find out later on that it involves factors that you did not anticipate.  Take your time when reading through the details.

Who Should Consider Equity Linked Annuities

In the current market environment people who are afraid of direct exposure to the stock market but are less than impressed with fixed annuity rates should consider an Equity Linked Annuity.  You can have the potential of greater returns if the stock market goes up and you are risking very little to get that opportunity.  Interest rates on fixed annuities are at all time lows.  If you don’t mind potentially getting no return, you may be able to get a good return without all the extra risk to your principal. 

Most major insurance companies sell Equity Linked annuities.  Companies like MetLife, GenWorth, Prudential and Pacific Life are just a few of the companies that offer these types of contracts.  Be sure to check the insurance company’s credit ranking because this is what guarantees the safety of your principal with this type of contract.  Insurance companies typically do not fail but they have in the past and you are better off working with a solid company from the beginning.

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