Equity Annuities: Managing Retirement Risk
Equity annuities offer a good avenue for managing retirement risk because they provide the potential for a good return without the potential losses of principal associated with traditional investments. Equity annuities invest most of their premiums into a fixed annuity, with the rest placed in several equity-index call options.
Owners of equity annuities do give up some potential gains in exchange for the no-risk feature, but the equity-annuity approach remains attractive to retirees and to individuals who are nearing retirement. Their retirement assets are totally protected from loss - and are guaranteed to achieve a gain - so they experience the chance to share in rising markets. Investors who have suffered from market volatility find the trade-off offered by equity annuities to be a prudent approach.
Equity annuity plans work by indexing, or linking, their credited interest rate to an equity index, like the Standard & Poor's 500 Composite Stock Index or the NASDAQ. While the credited rate is connected to the stock market in this way, the amount of the principal investment is never put at risk. This means that a declining stock market will not have a negative impact on the value of assets held in an equity annuity.
Equity annuities, also called equity-indexed annuities, differ from other kinds of fixed annuities in the way they credit interest to the contract's value. Most fixed annuities calculate interest on the basis of a rate established in the contract, but equity annuities determine this rate with a mathematical formula that reflects changes in the index to which the plan is tied. With this formula, additional interest is calculated and then credited. The amount of additional interest depends on the specific features of the annuity.
An equity-indexed annuity is similar to other fixed annuities in that it guarantees to pay a minimum interest rate, which will be applied even if the interest rate linked to the index is lower. So equity-indexed annuities are a good choice for investors who want to maximize their gains at little risk. If the stocks in the market lose value, these annuity plans do not suffer any losses, but if the stocks rise in value, the annuity owner benefits from the increase.
The company that issues the equity-indexed annuity will impose a limit on the maximum returns to be received from a bull market, however. This is the trade-off for the protections they offer during market downturns. The limit is based on the indexing method used by the annuity company. The most common method is the participation rate, which is typically set at 90 percent. This means that the annuity is credited with 90 percent of the growth in the index.
Some equity-indexed annuities use the annual-reset method to credit interest. This lets investors lock in permanent gains in a rising market, while the annuity "resets" during a volatile market period and locks the rate in to a lower level. The lower this reset level is, the greater the chance for future gains.
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