What is an Equity Indexed Annuity? 

An Equity Indexed Annuity (EIA), often referred to as a fixed indexed annuity or simple indexed annuity, is a type of unconventional financial asset that is typically considered as an alternative to conventional investment assets such as fixed-rate and variable-rate annuities. Equity Indexed Annuities are especially suitable for conservative investors that typically prefer securities that involve lower risks. These securities are unique in the sense that their interests, yields and returns are partly based on equity indices, such as the Standard & Poor's 500 Index (S&P 500).

How Does an Equity Indexed Annuity Work?

An Equity Indexed Annuity (EIA) is a popular investment vehicle for funding retirement. It offers a guaranteed minimum investment return along with the opportunity to share in stock-market gains. However, these annuities do not directly invest the money put down by the investor in the stock market. On the contrary, the money accumulated via EIAs is invested partially based on an equities index, and the investor is offered a percentage of the index gains over a stipulated period of time, or a guaranteed minimum return in the event of a stock market decline.

Calculation of the Index-linked Interest Rate of an EIA

An Equity Indexed Annuity may use different combinations of indexing features in order to determine the index-linked gain. These indexing features have a significant impact on the return on investment. Below are some common indexing features employed by EIAs.

• Participation Rates: Participation rates determine what portion of the increase in the index will be used to calculate index-linked interest for the EIA.
• Spread, Margin and Asset Fees: Several EIAs use spread, margin or asset fees in lieu of participation rates, while some others use a combination of participation rates and spread, margin or asset fees.
• Interest Rate Caps: A cap is an upper limit that certain EIAs apply to the return. Expressed as a percentage, the cap rate is the maximum rate of interest that the annuity will draw.

Indexing Methods of EIAs

There are six primary indexing methods employed by Equity Indexed Annuities. They are:

1. The European Method (Point-to-Point Method): This method is the simplest of the six and involves a division of the index on the maturity date by the index on the issue date, followed by the subtraction of 1 from the result. This method essentially records the change in the index from the beginning of the term to the end of the term.
2. The Asian Method: This method averages several index points in order to derive the beginning index or the ending index, or both. The Asian method safeguards investors from the risk of a market decline on the date of maturity.
3. The High-water Mark Method: This method records index levels on each policy anniversary and assigns the highest of these as the index level on the date of maturity.
4. The Low-water Mark Method: This method records index levels on each policy anniversary before maturity and assigns the lowest of these as the index level on the date of issue.
5. The Ratchet Method: This method is also known as the Annual Reset Method and is one of the most complicated methods of the lot. It calculates the increase in the index each policy year by comparing the indices on the beginning as well as ending anniversaries. It then calculates appreciation by adding or compounding the increases for each policy year. However, the Ratchet Method completely ignores any resulting decreases.
6. The Spread Method: This method calculates the increase in the index for the term or the policy year in consideration and then subtracts a percentage from that change.

Advantages of Equity Indexed Annuities

An EIA typically combines the attributes of both a fixed annuity as well as a variable annuity with a view to incorporate the benefits of both types of annuities. The low-risk attributes of an EIA, coupled with a guaranteed minimum return, calculated on around 90 percent of the premium paid at an annual interest rate of 1% to 3%, have made it a popular type of annuity. Moreover, since the return of an equity indexed annuity is tied to the performance of a benchmark equity index, the investor is very likely to derive higher gains when the stock market rises. Conversely, in the event of a fall in the stock market, the investment is still hedged by the guaranteed minimum return, which means that investors are less likely to lose their principal. Thus, EIA are best suited for conservative investors that are willing to trade in some potential returns for a more secure investment.

Disadvantages of Equity Indexed Annuities

There are certain limitations of Equity Indexed Annuities as well. To begin with, EIAs are complex investment vehicles and are available in a wide variety of formats. This complexity often results in investors misinterpreting the operating mechanisms of EIAs. Secondly, there are instances where EIAs do not match the entire return of the market index they are tied to. This is because different EIAs employ different methods for calculating gains. Lastly, Equity Indexed Annuities carry surrender charges that may be as high as 20%. Since, most EIAs last 15 years or more, investors seldom have the option of accessing their money without paying steep penalty charges for years.