What is the Greatest Disadvantage of an Equity-Indexed Annuity?
EIA sales show an uptick, reflecting increased consumer interest for this packaged investment product. But do the promises made about EIAs match reality?
Index annuities typically limit index-linked gains through participation rate and rate cap restrictions, and charge an early withdrawal penalty of 10% before their surrender period has concluded.
Guaranteed Minimum Returns
Contracts governing equity-indexed annuities include certain guarantees, including a minimum rate of interest that is set by the insurer that issues and backs the contract. Furthermore, guaranteed minimum returns may be subject to caps which limit their rate of growth.
Some EIAs contain participation rates that limit how much of an index return is credited back to an annuity; for instance, if an index gained 10% and its participation rate is 80%, only 8% would be credited back. Some EIAs also incorporate spread, margin or asset fees that reduce index returns further.
Annuities often include fees that eat away at some of their gains, which will impact performance overall. Furthermore, annuities frequently contain performance floors to ensure minimum returns during market downturns – another reason investors must read carefully the terms of an EIA contract before buying one.
Fees and Penalties
Equity-indexed annuities come with various fees that could limit your overall return, such as administration expenses and extra riders. These costs could reduce the total return from index investments, with caps restricting how much gains can be realized from each index investment and floors protecting initial investments from losses. Additionally, insurance companies managing an annuity may charge participation rates, spread margin fees or asset fees or all three. In calculating index returns they often omit dividend income when computing total returns from an investment.
Like mutual funds, equity-indexed annuities grow based on the performance of an equities index. This index tracks information about the largest companies within a particular market and their performance over time. If it experiences positive performance in any given year, you will receive some index interest added to your contract value; otherwise no such additions will occur.
Taxes
Equity-indexed annuities earn interest by tracking market index performance; however, their contract features may reduce how much of that gain you can realize from tracking it. Such features may include participation rates, rate caps, spread/margin/asset fees and any charges that might reduce returns.
Indexed annuities provide investors with protection from investment losses by creating a floor, or buffer, that determines a maximum percentage loss on contract value regardless of index performance. Unfortunately, however, this also limits future earnings by decreasing the maximum percentage growth creditable to your account.
Index annuities generally don’t factor dividends into their calculations of index gains due to insurance companies that offer them. They don’t want to risk losing principal by including such an extensive amount of index gains in earnings calculations – therefore the returns you see from an index-linked annuity’s contract chart do not compare directly with investing directly in stocks and bonds.
Investment Risk
An annuity differs from mutual funds in that it requires more complex decisions to invest. Furthermore, many indexed annuities contain caps to limit your returns; most commonly this percentage of an index’s gains that will be credited back to you; this may occur monthly, annually, or once off. Some contracts even exclude dividends when considering index gains as a factor.
Other limitations can include participation rates or yield spread factors that reduce how much of an index’s return will be credited to your annuity and interest-rate caps, which set maximum growth rates credited back. These restrictions can significantly lower potential earnings should an index rise sharply. Furthermore, surrender periods often remain long for these investments, hindering investors who intend to use it as part of their retirement savings portfolios. Working with a financial advisor is helpful when considering these aspects as it relates to your own unique situation and financial goals.
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