Equity Indexed Annuity Pros and Cons

Why equity indexed annuities

When buying a home, you have to choose between an adjustable-rate and a fixed-rate mortgage. However, if there were a third option less risky than the adjustable-rate and beat the rates of the fixed, that would be the best option.

The equity-indexed annuities provide an ideal medium between the ho-hum rates of fixed products and the unpredictability of the variable contract returns.

Basic properties of equity-indexed annuities

Equity Indexed Annuity Pros and Cons

The equity-indexed annuity is a unique type of fixed annuity. An indexed annuity exposes you to the stock indices like the S&P 500 and guarantees the return of your principal investment. They enable you to capture the growth of your stock market while on safe ground. You will enjoy superior rates of return and also allow conservative investors to be at peace.  

These equity-indexed annuities work more like fixed counterparts. You can set maturities from 1-15 years and decline surrender charge as well as the tax-differed growth. Similar exemptions are done for probate and creditors.

For indexed annuities, your money is never at risk. Your money is tied to the market, but it is not invested in the market.

Equity indexed contracts differ from fixed annuities in that they don’t pay a set interest rate. You will receive a portion of any growth as posted by the benchmark stock index. Depending on various factors, the percentage of participation will range from 60-90%. For example, when you buy the S&P 500 and its index rises by 20% in a 7-year term, you will quickly realize ¾ of the growth without risking the principal.

A short history of indexed annuities

This is the latest form of indexed annuity available today. The Keyport Life Insurance Company introduced the Key Index product first in 1998. Today, there are over 40 life insurance carriers that offer these indexed annuity products.  

Since its inception, the rates of participation and caps of these vehicles have greatly improved. These companies are still working on providing other types of indexed annuities that guarantee safe market participation with differing levels of limitations.

Equity indexed annuities at work

Equity Indexed Annuities

When the investor pays the premium, the annuity carrier takes it. You can divide it into two parts:

  1. The big share portion invested internally in a stable portfolio of securities. It has a guaranteed grow-back to the full amount premium expected to be paid by the end of the contract term.
  2. The small portion presents the underlying stock index. It increases the sustainability in value when the underlying index rises. It rises exponentially to more the growth amount index.

Indexed annuity example

Company XYZ will pay the investor 85% of the yearly increase S&P 500. It guarantees a minimum of 3% per year and a maximum of 9% per year. If the index goes up to 10% per year, the annuity has to pay 85% of this. It can also be given as 8.5% of the indexed annuities, which guarantees a minimum return.

Some contracts will keep gains for one year and reset caps for each year. Others will calculate benefits cumulatively as per the term of the contract.

How are indexed annuities taxed?

They are taxed similarly to any other type of annuity. All the money in these tax vehicles is tax-differed until distributions are made. These distributions are reported and taxed like ordinary income. If a distribution is taken before the age of 59 ½, it comes with a 10-year early withdrawal penalty by IRS.

Premiums paid to these contracts are a tax-free return of principal. If you buy a $50,000 contract and it grows to $75,000, you start thinking of periodic distributions. 2/3 of each distribution will be considered as the return of the principal.

Payout methods

Equity Indexed Annuities

The payout methods for indexed annuities are:

  • Joint life – payments last up to when both beneficiaries are dead. It is calculated based on both life expectations. Same as straight life.
  • Straight life – you will receive a periodic dollar payment until you die. This payout offers the highest periodic payment. Your insurance carrier will keep the balance of the contract incase you die without receiving the full value of the contract.
  • Life with period certain – you will keep receiving periodic dollar payment until you die or you reach the set period. In the case of early death, there are options to protect beneficiaries from losing contract values.
  • Joint life with period certain – you and your beneficiary will receive payments until you both die or the end of the specified time reaches, e.g., 15 years.
  • Lump-sum – you withdraw the entire amount of the contract at once as cash or transfer it to a different annuity plan.
  • Systematic withdrawal – you will receive payments, which is a percentage of the contract value. It is used for IRA mandatory minimum distributions.

Why you need to consider indexed annuities?

If you seek higher returns than those provided by traditional guaranteed investments, indexed annuities are the best option for you. You don’t risk losing your capital. You must be prepared to absorb the loss of any real gains when the underlying benchmark index fails to perform well during the contract term. Indexed annuities are good for old investors who need exposure to equities.

Proper use of indexed annuities in your portfolio

Equity Indexed Annuities

There are no rules on how to position this in your portfolio. Consider an investor with $500,000 in their CDs and annuities portfolios. This individual will benefit from a long-term contract with the participation rate and a higher cap to shield them from inflation.

Watch out for scams and frauds

Indexed annuities are good for conservative investors. However, beware of unscrupulous financial advisors and insurance agents who deceive uneducated senior citizens into liquidating all their property and placing them into these contracts.

These contracts come with some level of liquidity but must not be the only option for use in a retirement portfolio. Watch out for invitations that say they will secure your retirement for life.

Equity indexed annuities for a safe retirement

piggy bank

When you retire or just about to retire, you need to seek options that will maximize your retirement savings and protect the money from loss. One excellent option for you is the equity-indexed annuity. This vehicle is not for everybody. They are still not entirely suitable for your retirement plan, either. You need to understand how they work regarding your retirement investment to enhance the safety and security of future finances.

Potential challenges faced by retirees

People in retirement or those who will retire soon are at the potential of facing several challenges. These challenges are not unique to anyone. They affect anyone regardless of occupation, demographic composition, status, geographic location, or financial capability.

Many retirees fear that they don’t have enough money. Many have inadequate savings to support their regular lifestyles after they retire. Living for many years is no longer a big deal today. That is because of modern medical advancement. According to LifeHealthPro, living past 100 years could happen routinely.

The stock market has been facing many downs in the past half-century. It means that even those who have saved enough for themselves could still be at risk during the next market decline. Make sure you own high-quality dividend growth stocks, and they will help minimize the damages to your income stream. There are, however, no guarantees in investing.

Pros and cons of equity-indexed annuities


  • The money that is held within fixed annuities is not subject to the volatility of the stock market. It is in no danger of decreasing value.
  • Fixed annuities offer lower interest rates than what is provided by investment-grade bonds, blue-chip dividend stocks, and more.
  • A performance cap is a limitation for an indexed annuity. Your insurance company will dictate the maximum percentage rate to be applied to your account for a given year.
  • The participation rate limits the growth of indexed annuities. It determines how much you need to increase the indexed value to calculate the interest credited to your annuity in a given year.
  • There is the surrender charge, which is controversial. Surrender charges dictate that the insurance company is allowed to keep a portion of your money in case you decide to close your account within a few fears. If you keep your money for over 10 years, surrender charges may be irrelevant for you.

Are all annuities and indexed annuities the same?

No. They all share the same basic working concept. They share similar EIAs. They also help you link your account value to a stock market index.

Each insurance company will have its unique surrender charges, participation rates, and performance caps. Evaluate your time horizon and goals to choose the perfect annuity for you.

There are many options available for all consumers and retirement investors. Don’t settle for less than what is perfect for you. Many insurance companies are willing to offer you exactly what you need. Choose an annuity that offers low fees. High fees will reduce the overall returns in your account.

The main problems with annuities


  1. Annuities are not investment products. Once you buy these products, there is no rate of return. It will take you many years to recapture your principal.
  2. Fees can be too much. Some agents will take up to 10% of the amount invested, which is a loss to you.
  3. The company can change the original interest rate that is credited to your account once a year.
  4. Products are usually purchased in a tax-differed account.

Are there other alternatives that could produce similar results?

Indexed annuities don’t suite everyone. They are also not mandatory for retirement investments. Make sure you choose the right product from a good company for a better experience.

One recommendable alternative is buying dividend stocks. That could give you a stable income in years to come. The dividends that you receive from your securities can be used to buy additional dividend stock shares.

Is it necessary to enlist the services of a professional advisor?

Seeking advice from a financial advisor will help retirees arrange their savings and minimize their fears. Advisors will be able to present more suitable options, especially for retirees, by enlightening them on the pros and cons of each one of them so they can settle for the best. Around 62% of people at present age feel the need for a financial advisor when making decisions every step of the way.

It is not easy to determine the plan that will give the biggest returns. Familiarize yourself with the features and characteristics of each plan and choose the right one that you see. Don’t make hasty decisions. Ensure that you have full insight into what you settle for and make an informed decision about it. If you choose right, you are going to enjoy your retirement in peace.

Final word

Equity indexed annuities are suitable for conservative investors. However, they can easily be misused. Make sure you understand all the rules and regulations in the contract. You can consult your life insurance agent or your financial advisor for better guidance on such matters.  

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