Benefits of Equity Indexed Annuities
In the last 15 years, equity-indexed annuities have become a popular addition to the roster of annuity products. They offer a solid list of benefits to prospective purchasers. These benefits more than offset the complicated mechanics and ground rules of this asset.
Structure of Equity-Indexed Annuities
The basic concept of an equity-indexed annuity is simple enough. Rather than crediting the annuityholder’s account with an annual interest return that is fixed in advance – as does the fixed annuity – the equity-indexed annuity provides a return whose magnitude depends on market performance. That performance is measured by an index of average performance, represented by an index number. Percentage changes in the index number reveal the average percentage by which the overall market has risen or fallen. The index is normally tied to the performance of equities (stocks); the most popular index is the Standard & Poor’s Index of 500 Stocks. When the S&P rises over the course of a year, the credited interest return also rises.
A pure indexed asset would precisely reflect the performance of the index. If the S&P 500 rises by (say) 15%, the credited interest rate would increase by 15%; a decline of 10% in the index would produce a corresponding 10% decrease in asset value. That is not how equity-indexed annuities work. Interest is credited asymmetrically to the annuityholder’s account. Percentage increases in the index number (rising market performance) are credited to the annuityholder to a degree described by the participation rate. A participation rate of (say) 75% would credit the annuityholder with a 7.5% return on an index-number increase of 10%; a participation rate of 80% would yield an 8% return to the annuityholder. Even this partial credit may be limited by an interest cap, which is a ceiling beyond which no further market increases are credited to the annuityholder. In contrast, the crediting of market decreases is typically non-existent; the equity-indexed annuity generally places a floor of zero under the annuityholder’s return, even when the market index declines.
Benefits of Equity-Indexed Annuities
There are two benefits of equity-indexed annuities that stand out clearly from their structure. The first is a higher average rate of return than a fixed-income asset such as a bond or CD. Stocks have a long-term return that exceeds that of bonds by a few percentage points, in spite of the fact that stocks occasionally decline significantly over the course of a year. The equity-indexed annuity lets the annuityholder keep most of the annual gains, though not all, but wipes the market declines off the books. The result is a long-term average return somewhere in between that of stocks and bonds.
The second benefit of equity-indexed annuities is risk-reduction. Risk is defined as the variance of possible outcomes. The first law of finance is the tradeoff between risk and return. All other things equal, a higher risk must be compensated for by a higher rate of return, while a lower risk implies a lower rate of return. Equity-indexed annuities reduce both the upper and lower boundaries of returns to the market index, thereby reducing the risk of owning the index. Risk-reduction is akin to buying insurance because cost substitutes for risk. The cost is the lower average return that accompanies the lower risk. The reduction in risk doesn’t necessarily imply that the benefit outweighs the cost, any more than insurance is always worth the premiums – that depends on the attitudes of index holders.
A third unique benefit of equity-indexed annuities is similar to the benefit enjoyed by investors who purchase the index outside the annuity. That is the liberation from active management of the asset. For example a mutual fund portfolio combines automatic diversification with professional management. The managers try to exceed the returns earned by other managers by picking particular stocks that they regard as undervalued. Modern portfolio theory, however, stresses the impossibility of “beating the market.” Investors who accept the average return embodied in the index are acquiring a very low-cost product. On balance, active management is unlikely to produce long-term returns superior to the average market return of the index.
Other benefits are duplicated by other types of annuities. These include a liquidity provision allowing a portion of the principal to be withdrawn each year penalty-free. Surrender charges may be waived if certain hardship conditions (such as terminal illness) are met. Annuity gains accumulate tax-deferred until distribution. Not to be overlooked is the privilege of annuitization, which provides guaranteed lifelong income.
One rather dubious benefit that will soon be available is the coming changeover in annuity regulation. Beginning in 2011, equity-indexed annuities will be regulated as securities by the Securities and Exchange Commission. Among other things, this will require the issuance of a prospectus to would-be purchasers.
Don't Just Shop, Implement a Solid Retirement Strategy
Purchasing an annuity is a big decision. Online research is a good start, but prudent investors should discuss all their options and risks with an independent financial advisor. Request a free, no-obligation consultation today, along with a report of current rates on brand-name annuities.Speak with an advisor over the phone about annuities for FREE.
Are the Benefits of Equity-Indexed Annuities Worth It?
All attitudes toward risk are not alike. Some people willingly embrace at least some forms of risk, while others are allergic to it. The existence of markets for risk, such as the insurance market, is testimony to the need for a mechanism to price it. The existence of a price allows people who find the benefits of risk-reduction worth their cost to buy that risk-reduction, while allowing those for whom cost exceeds benefit to bear the risk.
Owners of stocks who value the risk-reduction achieved by equity-indexed annuity more than they value the higher average return of stocks will reduce their stock portfolio by buying equity-indexed annuities. Those who value the extra return more than the lower risk will shun them. Equity-indexed annuities are more risky than fixed annuities because the equity-indexed return varies while the fixed return does not. Those holders of fixed-income instruments who value the extra yield of the equity-indexed annuity more than they value the stability of the fixed return will reduce their portfolio of fixed-income assets by buying equity-indexed annuities. Those who value the lower risk more will shun them.
The recognition of tradeoffs and of the differences in attitudes toward risk is characteristic of an economist. It is what separates the professional student of investment from the layperson. Nonprofessionals ask the question “Is it a good investment?” without realizing that it cannot be answered out of context. What is good for some people is less good (or even bad) for others.
In addition to benefits shared with other annuity products – which include annuitization, tax deferral of investment gains, limited liquidity provisions and hardship waiver of surrender charges – equity-indexed annuities offer some unique advantages. The first of these is an average return higher than normal for other fixed annuities or fixed-income assets. Secondly, by reducing the variance of returns on both the high and the low end, equity-indexed annuities reduce risk compared to stock ownership and increase returns compared to fixed-income asset ownership. The main purpose of indexation is to provide a low-risk, low-cost way for fixed-income investors to increase their yield while liberating them from the burden of active investment management. Some investors will find the reduced risk relative to equity investment to be worth the lower yield. Other investors will find the higher yield compared to fixed-income investments to be worth the higher relative risk. These groups comprise the customer base for equity-indexed annuities. Like virtually all other investments, an equity-indexed annuity is “good” for some people and “bad” for others, depending on the value they place on yield and risk-reduction, respectively.
To find the best annuity products request a free, comprehensive quote comparision. Secure your retirement today, Get Started Now.