What are equity-indexed annuities? What are the main problems associated with them, that investors need to be aware of? Read, to find all the answers and more.
Never before have we seen such variety in investment options, as there is today. The rate of return on an investment is often directly proportional to the degree of financial risk involved. When thinking of investments, as part of retirement planning, one looks for low to medium risk options. Annuities are some of the preferred investment options for those who are looking for long-term gains. There are various types of annuities, including the fixed and variable type.
About Equity-Indexed Annuities
An annuity is actually an insurance product which provides the annuitant with regular payouts till a fixed point in time. In case of a single and straight life annuity, an annuitant receives payment till the end of his or her lifetime.
The interest accrued on your investment is either fixed or variable and the annuity is either known as a fixed or variable annuity respectively. In case of equity-indexed annuities, the returns on the principal amount invested, are linked with the performance of an equity index.
There is a fixed part, known as guaranteed return, that an annuitant will receive and a variable part, which depends on how well the index (like S&P 500) performs in the stock market. The major USP of this type is the high rate of return, that it promises for the future.
When the market index performs well, a greater slice of return is provided to the annuitant, but limited by a maximum cap. However, in case of negative dips of the index, the size of returns is not lowered, which protects the investor from the negative trends of the market. An investor can only gain, while the insurance companies protect them from losses. They come with a surrender period, which is usually more than 10 to 15 years.
The way in which the interest is calculated, with respect to the index, may be different for every insurance company, which makes it highly confusing to understand. Following are some of the problems with this annuity type.
Participation Rate and Low Cap Limit Returns
The participation rate decides how much interest you earn, from the rise in stock index value. If the market rises 10% and your participation rate is only 70%, you will receive an interest of 7% (which is 70% of 10). In addition, some insurance companies put a cap percentage, beyond which your interest cannot rise. These two factors can eat into your returns substantially.
Penalties from Early Withdrawal
If you need to get the invested money back due to an emergency, before the surrender period is over, you will pay a huge amount in penalties, which will bring down your returns substantially. Take this factor into consideration before buying one.
Risk of Index Non-Performance
What if the index does not perform? That question always keeps hovering. If it indeed fails to perform, you will only land up with the guaranteed rate of return. In addition to this, a percentage of returns are deducted from your returns as spread or margin fees. All this adds to the inherent risk, which arises due to market index dependence.
It is important that you read the conditions that dictate the calculation of your returns, associated with equity indices. Get a realistic estimate of the size of returns and know the degree of risk involved, before going ahead. Badger the insurance company with questions until you are aware of the whole picture regarding the investment you are making. After all, it is your money and you have a right to know.