Equity Indexed Annuity

Would you like an investment that pays gains based on the stock market, yet helps protect your principal when the market declines? A safe place to grow your money?

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It’s not every day that you find the opportunity for potential growth with true safety in the same financial vehicle. Usually investors are compelled to make one of two choices, either they give up a degree of safety in exchange for a greater potential for growth or they accept less growth in exchange for a higher degree of safety. Thanks to an innovation in the insurance industry, you can have the potential high returns available in the stock market and the security of a guarantee—it’s called an equity indexed annuity.

Equity indexed annuities are excellent alternatives for investors seeking safety in a low interest rate environment or a volatile market. Here’s how they work, your return is based on the increase of a stock or equity index, such as the S&P 500.1 If stocks rise, you benefit from the increase. If stocks fall, you do not lose any money, most contracts guarantee a minimum return, typically 3%.2 This is what makes these newer products so attractive to retired persons and to those approaching retirement.

Now, imagine this scenario: Suppose you and I take a trip to Las Vegas for a week. I decide to make you the following offer. You can gamble at one of the casinos as much as you like for the entire week and I will guarantee you in writing that no matter how bad you do you will not lose. In fact, I guarantee that you will walk away from the tables with no less than what you started with, plus some interest. If you win, you get to keep the winnings.

Would you take me up on the offer? I would imagine given that opportunity, you would load up with casino chips as soon as possible. So, what’s the catch? You can’t lose a dime, but the catch is, you have to play for the whole seven days, otherwise you may have to give back a small portion of your chips. In other words, if you invest with the intent to hold your investments for some time down the road, index annuities can be a powerful investment. This brief example is simplified, but in very basic terms, this is the concept behind equity indexed annuities.

Obviously, there is no such thing as a free lunch, so the company that issues the annuity will limit the maximum returns that you receive from a rising market in return for the downside protection they provide. This limit depends on the particular indexing method that the annuity company uses. The most common method used to limit returns is something called the “participation rate.” For example, the insurance company may set the participation at 90% (some companies are as low as 50%), which means the annuity would be creditedwith 90% of the growth experienced by the index. If the index gained 10%, your gain would be 9% for that year. Essentially, you’re trading 100% of the market risk in order to receive a share of the market gain.

In addition to the different participation options, there are index annuities that use an “annual reset” method for crediting index-linked interest. This valuable method allows you to lock in gains permanently in an up market. In volatile markets where the index declines, the annuity simply resets locking you in at the now lower index level. In fact, some index annuity renewals have been reset at very attractive levels. The lower the reset is, the more opportunity there is for future growth.

Let’s take a look at another tough time in the market and see how the index annuity would have performed utilizing the annual reset method. One of the best examples of a prolonged bear market was the 1970’s, in the 1973-74 downturn stock prices fell more than 40%. The S&P 500 closed at an all time high towards the end of 1972 and it wasn’t until 1980 that these levels were retraced. So, if you bought at year-end in 1972, it would have taken about 7 years to break even using the traditional buy and hold technique. Utilizing a 90% participation index annuity with the annual reset method from 1972 to 1979 would have resulted in a return for those seven years of approximately 70%—even though the index had not yet returned to its former high.

In today’s market environment it’s hard to beat an annuity that only goes up. Many seniors who fled the stock markets, locked in gains and purchased equity index annuities. They are now waiting for an upturn, which will produce further gains for them, not just a recovery to former highs. The use of these vehicles has allowed them some comfort during market declines.

Due to the complexity of equity index annuities I strongly suggest you consult with a knowledgeable investment advisor to see how they might fit into your financial plan.

Endnotes
1. The S&P 500 is an unmanaged broad based market index often representative of the stock market as a whole. An investment may not be made directly in the index.
2. Equity indexed annuities are long term investments subject to possible surrender charges and 10% IRS early withdrawal penalty prior to age 59 ½. Current interest earnings linked to the growth of the equity market. Minimum return, principal value and prior earnings guaranteed by issuing insurance company, subject to their claims paying
ability, when held to the end of term. Risks include inflation and default risk.