Equity Annuity Primer

In this equity annuity primer, you'll learn what you need to know about equity-indexed annuities, a relatively new form of annuity plan designed to combine features of stock investment plans and those of traditional fixed annuity plans. The equity annuity primer will discuss the nature of equity-indexed annuities, the risks associated with equity-indexed annuities, and the various ways interest rates for equity-indexed annuities are calculated.

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What Are Equity-Indexed Annuities?

Equity-indexed annuities are unique contracts made between an investor and an insurance company in which the insurer credits the investor, during the accumulation period, with a return that is based on changes in an equity index like the Standard & Poor's 500 Composite Stock Price Index. The accumulation period is when the investor makes a lump sum payment or several payments to fund the plan. The insurance company provides a guaranteed minimum rate of return. When the accumulation period ends, the insurer makes periodic payments to the investor under conditions specified in the contract. Investors may also choose to receive the contract's value as a single lump sum payment.

The Risks of Equity-Indexed Annuities

Investors may lose money if they buy equity-indexed annuities, particularly if they decide to make an early cancellation of the contract. And even with the guaranteed rate of return promised by the insurer, investors can lose money if the guarantee is based on an amount less than the total amount of the purchase payments. It can take several years for the minimum guarantee in an equity-indexed annuity to reach a break-even point.

There are also substantial surrender charges and tax penalties imposed if the investor cancels the plan early, and some insurance companies may not credit the interest tied to the index if the contract is not maintained until its maturity.

Features of Equity-Indexed Annuities

These contracts are complex and may comprise a number of features that will affect the return they provide. Investors should make sure that they understand the way in which an equity-indexed annuity calculates the index-linked rate before they purchase the plan.

The indexing method can also have a major influence on the returns from an equity-indexed annuity. The indexing method refers to the way the amount of change in the selected index is determined.

Pros and Cons of Equity-Indexed Annuities

Equity-linked annuities are complicated, and they differ according to the insurance company that provides them. For example, some insurers will guarantee that investors will receive at minimum 100-percent of their invested money, but others guarantee only a 90-percent return. And some insurance companies may subtract expenses from gains before even calculating the net return on the equity-indexed annuity.

Additionally, equity-indexed annuities are not subject to regulation by the Securities and Exchange Commission (SEC) or the National Association of Securities Dealers (NASD), so there are no institutional protections for investors. The lack of regulation also means that sales persons are not required to be licensed to sell securities and no prospectus defining the annuity's rules or expectations is provided.

Investors should be cautious and be sure to get their contract details in writing and to perform due diligence, rather than rely on the promises of a sales person who is working on commission.

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