Annuities are one way to fund your retirement. With an annuity, you exchange a certain amount of principal up front for payouts in retirement. An equity-indexed annuity is a popular type of annuity. The payout for these annuities is based on the performance of an equities index, like the S&P 500.
An equity-indexed annuity is slightly less risky than other some other types of annuities. That’s because it offers more protection against a market downturn and follows the principles of indexed investing that are popular among conservative investors.
How Equity-Indexed Annuities Work
An equity-indexed annuity works just like any other annuity in terms of investing. You’ll pay a set amount of money to an insurance company. That money is then invested into various accounts or securities. Then comes the accumulation period, when the money you invest earns interest or gains value on the market. Then comes the payout. You will receive a series of payments for a predetermined length of time. Generally, you’ll start receiving payments once you retire.
Equity-indexed annuities are unique because the money you pay to the insurance company is invested partially based on an equities index. An equities index is a measurement of the overall health of the stock market. It gathers information on the performance of a collection of the biggest companies in a market and tracks how they do. As the market goes up or down overall, so does the index. Index funds are a popular investment that simply invest in the companies in an index and track with the market. Equity-indexed annuities work the same way.
Equity-Indexed Annuity Payouts
Market performance isn’t the only factor that determines returns from an equity-indexed annuity. There is a guarantee of some payback. Generally, this is a 1-3% interest rate on 90% of the premium. The investment in the specified equities index determines the rest.
This guaranteed interest provides downside protection, meaning that you are less likely to lose your principal. The flip side, of course, is that you stand to make less money than if you simply invested in the market and it went up. You are, in essence, trading some potential returns for a more secure investment.
This protection makes equity-indexed annuities a favorite of conservative investors. The payout won’t be as high as it could be with some other investment products. However, there is less risk involved. Thus, you likely aren’t going to see big losses that could seriously impact your retirement plans in a negative way.
Downsides of Equity-Indexed Annuities
As with any investment or savings product, there are risks and downsides that come with using an equity-indexed annuity as part of your retirement savings plan.
One downside is that your yield will be relatively modest. If you have other retirement savings, like a 401(k) plan, an IRA or a pension plan, that might be okay for you. In that situation, the equity-indexed annuity will simply serve as an extra chunk of change for your retirement, not the sole source of your retirement income.
Most equity-indexed annuities have a participation rate that limits the investor’s gains. Let’s say the participation rate for a particular equity-indexed annuity is 75%. If the index it is linked to shows 10% growth, then investors will only see 7.5% of that profit. This is obviously a lower return than if you simply invested in an index fund. Some equity-indexed annuities also have a cap on total interest that you can earn.
You should also take note of the fees associated with equity-indexed annuities and other investment products. Equity-indexed annuities have sometimes attracted criticism for having high fees. Thus, you should make sure to figure out exactly what you’ll be paying before you purchase an equity-indexed annuity as part of your retirement plan.
One of the most troublesome fees for equity-indexed annuities is the surrender fee. A surrender fee is levied when you withdraw principal from an annuity before the predetermined surrender period has ended. For equity-indexed annuities, the surrender period can be as long as 15 years and the surrender fee can be as high as 20%. This means that when you choose to use an equity-indexed annuity, you’re locking yourself into a situation where you can’t touch your money for a long time unless you pay a pretty hefty fee.
The Bottom Line
An equity-indexed annuity is an annuity product in which the principal you put in is invested in a stock market index like the S&P 500. A guaranteed interest rate determines roughly 90% of the returns, while the performance of the index determines the rest. Equity-indexed annuities are generally fairly low risk, but they are not going to offer as big of returns as some other investment products and also can carry high fees. You likely won’t want to count on them as a primary source of retirement income.
- Investment products, especially annuities, can be confusing. A financial advisor can help you sort through it all and decide which investments are right for you. SmartAsset can help you find a suitable advisor with our free financial advisor matching service. You answer a few simple questions and then we match you with up to three advisors in your area. We fully vet all advisors on our platform and ensure they’re free of disclosures. Then you can talk to each advisor and ask them questions, figuring out who is right for you.
- Whether or not you use an equity-indexed annuity, index-based investments are a good option for investors. This is especially true if you want a cheap alternative to actively managed funds. Consider index funds if this appeals to you.
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