Posts Tagged ‘fixed rate annuity’

What is an Equity Indexed Annuity?

If you are considering the purchase of an annuity, you may be thinking that you either do a variable annuity or a fixed annuity. A variable annuity allows you to benefit from investing in the stock market which can have its ups and downs. No pun intended. You may want the chance to make gains when the stock market goes up but you may also have a high degree of fear that you will lose money when it drops.

You may think that the only other alternative to the stock market and a variable annuity is a fixed rate annuity that will not fluctuate but which currently pays very low fixed interest rate returns. What if you could have a bit of both of these types of annuities? That is what an Equity Indexed Annuity offers.

You can have the assurance that you will not lose money if the market goes down but you have the chance to benefit to a limited degree if it goes up. There is a price to pay for this benefit. Not only are there fees included inside your contract for this benefit but you will give up some of the yield you would get on a traditional fixed annuity. If you can get a fixed rate 7 year annuity paying you a guaranteed 2.5%, you may only get 1.75% guaranteed on an equity indexed annuity. Why? Because you are giving up a bit or your guarantee for more potential upside gain.

How does an Equity Indexed Annuity Work?

When you purchase your equity indexed annuity you will be given a rate of participation percentage. You may be able to participate in the upside of the market with a 70% participation ratio. That means that if the Index that your annuity is tracking, which is typically the S & P 500, goes up 10% for the year, you will receive an interest credit of 7% for that year. Most contracts have a limit to the interest rate you can be credited.

An example of an equity indexed annuity may be one where you invest $200,000 initially. You are guaranteed to get no less than a 1.5% annual interest credit. However, you can participate at an 80% ratio up to a maximum of 8% per year. Suppose in your first year the S & P index moved up 12%. That means that you would receive an 8% interest rate that year. Why not 9.6%? Because you are capped at 8%.

Suppose that the next year the market goes up only 7%. You would get an interest credit of 5.6% for the year. (80% of the 7%) However, say in the third year the market goes down 30%. Your principal would not go down but you would only get credited a 1.5% interest rate. This is a simple example but you get the idea. This type of annuity gives up potential for greater gain but not so much of a guaranteed rate of return.

Who Should Consider an Equity Indexed Annuity?

The type of person who should consider an Equity Indexed Annuity is someone who has a few years until they retire. This gives them some time to try and get a larger return with stock market gains. In the current economic environment though where fixed rates of return are so incredibly low, it may be the best way to go for people in close to retirement.

Current fixed rate annuities may pay 3% if you are willing to lock in that rate for 10 years. At this rate the cost of trying to get a higher return by investing in an Equity Indexed annuity is minimal. If you can handle potentially getting 1.5% lower return each year, you may find that over time you do much better with an indexed annuity than with a fixed rate annuity.

If interest rates were higher currently on fixed annuities it may be a bit more tempting to just lock in a fixed rate and forget it. However, at a cost of 1% or 2%, what’s the big deal? Right? As recent as 3 years ago, a person could lock in a rate of 4.5% on fixed annuities for 5 years, but those days are gone now.

Important Issues to Consider When Shopping for an Equity Indexed Annuity

Unlike variable annuities, equity indexed annuities do not invest in mutual funds. They invest in fixed income instruments. Their security is directly tied to the credit strength of the insurance company that is offering them. If the insurance company goes into bankruptcy, your annuity will be paid back according to bankruptcy court rulings. That means you can lose your money if the insurance company goes under.

It is a rare event to see an insurance company go bankrupt, but it has happened. With the current world economic instability, it is very important that you select an insurance company with a rock solid financial standing. John Hancock is one of the top ranked insurance companies in the industry. New York Life in another top ranked company. Pacific Life, American National and Prudential are a few other names that are in pretty good financial standing.

You should do some research and make sure that the company you are dealing with has one of the top financial ratings available. Moody’s and Standard and Poor’s as well as Best’s all put out credit ratings for insurance companies. Don’t invest until you do your homework.

Conclusion

As mentioned earlier, in the current low interest rate environment we are in, it may be worth looking at an Equity Indexed annuity for your retirement. We can’t say for sure what will happen with the stock market over time, but the cost of trying for higher returns is very low right now.

You should compare the internal costs of the annuities offered by the top ranked insurance companies on these types of contracts. Also compare the minimum rates of return and then make your selection.