An equity-indexed annuity is an annuity that's value is linked to a stock or market index; the S&P 500 index is most common. Equity-indexed annuities have a guaranteed minimum rate of return (also referred to as a floor). This guarantee is usually between 0 and 3 percent annually. In exchange for this guarantee, equity-indexed annuities also have a cap, which is the maximum rate of return the investment can make in a given year. Currently, most indexed annuities have a cap of around 7 percent. Consequently, if the index the annuity is linked to returns 10 percent in a given year, the investor would only be credited with a 7 percent rate of return.
Every equity-indexed annuity has a participation rate, which determines how much of the index's increase will be used to compute the annuity's rate of return. Currently, most indexed annuities have a participation rate of between 70 and 100 percent. If the index rate of return during the year was 7 percent, an index-linked annuity with a participation rate of 80 percent would increase in value by 5.6 percent (calculated 80% of 7%, or .8 x .07).
Equity-indexed annuities offer investors a way to participate in market gains while minimizing risk. However, keep in mind the S&P 500 has returned an average of 10 percent annually over the past 100 years, and the majority of these returns have come during years when the market performed much better than a 10 percent rate of return. Thus, an index-linked investment with a cap of 7 percent and a participation rate of 80 percent may dramatically reduce returns over an extended period of time. Additionally, surrender charges are frequently attached to these investments, limiting the investor's ability to sell without penalties.
Equity-indexed annuities are complex investments. Unfortunately, salespeople are offered high commissions to sell these products. To increase consumer awareness, the SEC developed documentation intended to educate investors about the pitfalls associated with these investments. That document can be viewed at sec.gov/investor/pubs/equityidxannuity.htm. Consult with an independent fee only financial planner who is never paid commissions to determine if these investments are really appropriate for your situation.