Equity Indexed Annuities

Sales of equity-indexed annuities (EIAs) have increased tremendously in recent years. As investments, EIAs are considered to be suitable for the portfolios of individuals who want to avoid major risks, such as those approaching or in retirement. Although they are marketed as relatively “safe” investments, EIAs are complex products that are very difficult to fully understand. Unlike many other investment products, EIAs are so complex that the structure of one EIA can be completely different than that of any other.

What is an Annuity?

Before one can attempt to understand an EIA is, it is essential to understand what an annuity is. According to FINRA, an annuity is a contract between you and an insurance company in which the company promises to make periodic payments to you, starting immediately or at some future time. The payments are made to you in return for a single payment or a series of payments called premiums.

Traditionally, there have been two common types of annuities: Fixed and Variable. A fixed annuity is one in which the insurance company makes fixed payments over the term of the contract. Those fixed payments are calculated based on an interest rate that is defined within the contract. A fixed annuity is considered to be an incredibly safe investment due to its simplicity and predictability. On the other hand, a variable annuity’s rate of return is unpredictable, and varies according to the performance of the stock, bond and money market investment options that you or your broker choose. Since the return on a variable annuity is dependant on other factors, they are considered to be a more risky investment. As is often the case with risky investments, the potential reward is greater than that of a fixed annuity.

What is an Equity-Indexed Annuity?

In terms of risk levels, EIAs lie in-between fixed and variable annuities; they retain greater risk than a fixed annuity, but less risk than a variable annuity. Like fixed annuities, EIAs contain a guaranteed interest rate which can be received if the product is held to the end of the contract. Similar to variable annuities, EIAs also depend upon the performance of something else. Rather than depending upon the performance of a particular security, an EIA is dependent upon the performance of a market index.

What is a Market Index?

According to FINRA, a market index tracks the performance of a specific group of stocks representing a particular segment of the market, or in some cases an entire market. Most EIAs are based on the S&P 500, but other indexes can also be used. The fact that the returns on EIAs are linked to more securities, or an entire market, is part of the reason why EIAs are less volatile than variable annuities, whose returns can be reliant upon individual securities.

What Makes EIAs so Complex?

The index-linked gains that make up EIAs can be calculated in many different ways. The most common way is known as a participation rate. A participation rate is basically a limit on the amount which the annuity owner participates in market gains. For example, if an EIA has an 90% participation rate, and the index to which it is liked shows a 10% profit, then the annuity owner will realize a 9% profit. Since participation rates, market indexes, and interest rates for EIAs can vary, few EIAs are the same as one another.

EIA as a Retirement Investment

EIAs are generally considered to be good investments for individuals approaching or in retirement. This is due to the fact that there is a guaranteed return on the investment, which is typically around 90% of the premium plus 1 to 3 percent interest. However, if you decide to surrender your EIA early, there tends to be a large surrender charge and a tax penalty. Since these factors make EIAs strong long-term investments, they are typically considered to be suitable for those approaching or in retirement.

Brokers Must Match Investors to Investments

If you found all that hard to grasp, you’re not alone. However, it is not the duty of retail investors to fully understand the complex products contained in their portfolios. After all, you are probably a novice when it comes to complex financial matters. Your financial advisor, on the other hand, must not only understand the product he or she is selling to you, but he or she must also ensure there is a clear suitability match between you as an investor and the investments in your accounts. Certain securities are not for everyone.

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