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The introduction of the "equity-index" has revolutionized the insurance and annuity industry in recent years. Like other tax-deferred annuities, the equity-index annuity is a contract between you and an insurance company; however, it is considered neither a fixed rate nor variable annuity. Instead, the equity-index annuity forms a so called "hybrid" of these products by combining the safety and certainty of a fixed rate annuity with the upside potential of the overall stock market, similar, but not identical to variable annuities. By definition, the equity-index is a fixed product, meaning that it has no investment risk. While earnings can and do fluctuate during each policy year, they are credited to the annuity on each policy anniversary. Also, you cannot lose principal with an equity-index annuity, as is the case with a variable annuity.
Similar to variable annuity subaccounts, with an equity-index annuity, the annuitant selects from a menu of "asset allocation" accounts to proportion funds. Each of these accounts is based on certain index strategies, ranging from the S&P 500 Index to the Dow Jones Industrial Average. Thereâ€™s even a Total Stock Market index to choose from, among other Index choices. Performance of the selected asset allocation account is measured from the date the annuity is issued, then calculated and credited on each policy anniversary. Once credited, interest earnings are then "locked in" and become part of the principal amount, which is guaranteed, regardless of future performance. If performance is negative (at a loss), an alternative, guaranteed rate is then credited, which is usually around 1%. Under no circumstance can an equity-index annuity lose principal, regardless of the performance of the selected asset allocation account.
Because if its unique design, the equity-index annuity can be viewed as a modern solution to the age old question, "should I sacrifice safety for potentially higher returns?" Today, you can have both the safety and certainty of the fixed rate annuity and participate in what happens in the market through various index strategies. You can also earn a guaranteed rate return, even if the market loses money, while avoiding risk to principal, and you can keep what you earn, without the risk of losing those earnings in future years.
Equity-index annuities usually offer three different interest-crediting methods. Which method is available usually depends on the issuing company and the scope of their product offering. However, each of these methods is essentially a form of revenue sharing with the insurance company. Because equity-index annuities typically don't charge fees, the company profits by sharing in potential gains realized by the asset allocation accounts. This is done by either "capping" the amount that can be earned per year, outright sharing in the gain, known as "participating" or charging a "spread," which is a fixed percentage retained by the company before any interest is credited to the annuity.
Different that ordinary fees which are paid regardless performance, expenses associated with caps, participation rates and spreads are considered "indirect" fees because they are paid on the contingency that the selected asset allocation account realizes a positive return. Only then does the company actually profit. If a chosen asset allocation account loses value in a particular year, no fees are paid, either directly or indirectly through this revenue sharing concept.
Here is how each method works:
Rate Cap - A rate cap is simply a cap on the total amount of interest that can be earned within a specified year, for example 4%.
Participation Rate - The participation rate determines the amount of the gain that will be paid on a specific index. For example, a 40% participation rate would mean that the annuitant would receive 40% of the actual gain in a specified index. For example, a 10% gain in the specified index would therefore result in 4% interest being credited to the annuity (10% return x 40% participation = 4%).
Spread Margin - With a spread margin, a specified percentage of any gain is withheld by the issuing company as profit. Any gain beyond the spread margin percentage is then credited to the annuity on the policy anniversary. For example, if the spread margin on an annuity was 3%, and the actual gain in a specific index was 10%, the annuity would be credited with 7% interest (10% return -3% spread = 7%) on the policy anniversary date. Conversely, if the actual gain of the index were only 4%, then the annuity would be credited with 1% (4% return - 3% spread = 1%).
(Be sure that you understand how each crediting method works before purchasing an equity-indexed annuity. Talk with your insurance agent or financial advisor to learn more.)
One of the many features of an equity-index annuity is that interest earnings can grow tax-deferred, meaning that no current tax liability is due on interest (or asset allocation exchanges) until withdrawn. This gives the holder of an equity-index annuity an advantage over both fixed products such bank CD's or Treasury Bills, as well as, investments like stocks, bonds or mutual funds, which are all taxed, as earned, on interest and dividend distributions, if he or she doesn't need current income.
Like most annuities, equity-index annuities have early withdrawal penalties known as "surrender charges," however, these types of policies offer the annuitant a variety of liquidity options when it comes to making withdrawals. For example, should the annuitant need to make a one-time withdrawal or want to use their equity-index annuity to provide monthly income, he or she can typically withdrawal up to 10% of the surrender value each year, without penalty.
Equity-index annuities also offer a variety of other income options similar to those offered by immediate annuities. Some may also offer income riders, such as the "Lifetime Income Benefit Rider." While fees are often associated with this particular income option, they are usually justified by higher income payouts and better liquidity options than ordinary immediate annuities. To read more about lifetime income benefit riders, click here.
Two other liquidity options you might find associated with an equity-index annuity are the nursing home waiver and/or the terminal illness rider. The nursing home waiver allows the annuitant to surrender the contract in full, without penalty, if the annuitant is confined to a nursing home for 90 days or longer. Similarly, the terminal illness rider will waive any type of penalty on surrender, in the event the annuitant is diagnosed with a terminal illness. If included, neither of these features usually have any type of fee associated with them.
Although equity-indexed annuities do charge fees for things like income riders, which are optional, they typically do not have any other type of fees or expenses. The issuing company usually profits indirectly through rate caps, participation rates or spread margins. Depending on your view, and possibly which way the stock market goes in a given year, these profits can sometimes be justified when you consider the issuing company is assuming the downside market risk, providing a guaranteed minimum rate of return, and locking in possible gains from year to year.
All annuities allow you to name a beneficiary in the event of the annuitant's death. If properly designated, the proceeds of the annuity bypass probate and go directly to the named beneficiary.
Equity-index annuities give the annuitant the safety and certainty of a fixed rate annuity, combined with the overall upside potential of some variable annuities. They also generally have no direct internal fees or expenses and allow interest earnings to grow tax-deferred, until withdrawn. Once credited, interest earnings become part of principal, which is guaranteed. Equity-Index annuities have the potential to outperform both conservative financial products like bank CD's or Treasury Bills, as well as, more aggressive investments such as stocks, bonds and mutual funds, under certain conditions.
Like virtually all tax-deferred annuities, equity-indexed annuities have early withdrawal penalties should you decide you want all of your money back before the end of the contract term, which is typically a range from 5 to 10 years. However, most equity-indexed annuities offer a variety of income withdrawal options, which, if elected, will avoid any early withdrawal penalties. While equity-indexed annuities do not typically have direct fees, they do have "indirect" fees by way of the interest crediting method selected. However, this expense can sometimes be justified by the absence of any investment risk. Therefore, this point is more of a consideration than a disadvantage.
An equity-indexed annuity is considered a hybrid annuity. It combines the best features found in both the fixed rate and variable annuity, making them an excellent alternative to CD's, Treasury Bills and even stocks, bonds or mutual funds. The equity-indexed annuity offers both safety and the certainty of a guaranteed rate, regardless of market conditions. They also offer a menu of asset allocation options along with tax-deferred interest and a myriad of income options, including income riders designed to provide the annuitant with a guaranteed, lifetime of income without sacrificing liquidity.
As with any annuity, it is important to know what you are purchasing, how it works and the terms of the annuity contract. To find out more about equity-index annuities, contact us today or speak with your Alliance America Agent Advisor for more information.