Equity Indexed Annuities – Problems, Risks and Benefits

equity_annuityBaby boomers nearing retirement have taken an increased interest in equity-indexed annuities.  The reason is that an equity indexed annuity (EIA) is a financial product that allows its owner to participate in stock market gains while limiting downside risk if the market drops.

To provide this risk control benefit, most EIA’s are issued by insurance companies. The EIA issuer promises that at the end of the investment period, the annuity owner will receive either a lump-sum distribution of the proceeds or regular payments based on the accumulated balance.

Another reason that equity indexed annuities have become more popular is that they are almost perfectly designed to perform well in highly volatile markets, as compared to more conventional investment products. This has proven true as a consequence of what happened to equity markets in 2008-2009.  Since 1995, equity indexed annuities have outperformed both the S&P 500 and bond indexes. That’s hard for a baby boomer to ignore. So let’s take a closer look.

Benefits of Equity Indexed Annuities

The benefit of an EIA can be essentially summed up in a simple phrase: damage control. More specifically, using a formula that can sometimes be hard to decipher, the annuity owner benefits – or “participates” – in stock market upswings but without substantial risk of loss if the market declines. The insurers who sell EIAs use financial derivatives to put contractual “wraps” around the value of the annuities. These wraps limit both upside and downside for investors.

For example, a typical EIA may have a 70% participation rate. If the S&P climbs 10% during the year, the annuity owner receives a 7% increase in value. As consideration for not sharing in the other 3% of the market gain, the owner also receives a loss limit. This often guarantees that the annuity owner will do no worse than break even each calendar year. Thus, when the market fell 38% in 2008, owners of equity indexed annuities looked like geniuses because they lost nothing.

Problems and Risks Associated with Equity Indexed Annuities

The biggest problem with EIA products is that they are hard to understand and therefore difficult to compare to other annuities and investments. One confusing area is precisely how the EIA product participates in market gains. There are several factors to consider here:  rate of participation; participation caps; and any administrative fee that is subtracted from the gain.

The indexing method is also important. Different indexing techniques include Annual Reset, Point-to-Point, and High Water Mark. Each of these work differently in determining the participation gain starting and ending points for each annuity contract year.

Keep in mind that most EIA products do not credit dividends to the investment value. The annuity owner receives no benefit from those. That also depresses returns compared to a conventional equity investment.

For detailed explanations of these different EIA participation and indexing methods, try the FINRA (Financial Industry Regulatory Authority) site.

A second problem with equity indexed annuities is excessive fees. These include sales commissions and annual administrative costs. In most cases, these fees are substantially higher than a mutual fund product. Finding all of these different fees and expenses can be difficult. Transparency is not a strong suit of annuity sellers.

Finally, an equity indexed annuity can trap your money if you were to have a sudden need for it. By this I mean that most EIAs have substantial surrender charges if you attempt to liquidate your investment before the contract period ends. In some cases, an early surrender can cause the loss of any accumulated gains as well. So do not put money into an EIA that you might need in an emergency.

Bottom line: Think and study carefully before investing in an equity indexed annuity. A good place to learn more about EIA products is this annuity buyer’s guide from the National Association of Insurance Commissioners.

Good luck.

Photo credit: artemuestra


  1. says

    I personally like a fixed annuity as I know what I am going to be getting – the risk lies in inflation and my dollar not being worth as much but this can easily be countered by investing in a foreign currency where the dollar devaluation should correct the inflationary losses. Just pick the right currency.

    Jonathan Rose Company, LLC offers a product almost identical to an annuity but without the costs……

  2. GHL says

    The National Association Of Fixed Annuities is the best place to go for info on fixed annuities and fixed index annuities. Going to finra for information on fixed annuities is like asking the Hatfield s about the Mcoys while they are fighting. In fact if people would go to finra and the sec websites and read about the risk and cost of mutual funds and plug in 2% fee in the sec mutual fund calculator mutual funds would be deader than dirt.
    You said yourself the last fifteen years fixed index annuities had out performed mutual funds. For your information fixed index annuities have only been around only fifteen years.
    Mutual funds will always under preform they are a retail operation with everybody involved grabbing every cent they can get before the investor gets a dime.
    Maybe a good article would be why the average mutual fund turns over it’s entire portfolio at the rate of a 120% a year and what the strategy is for that move and why that is good for the investor.
    I do not expect this comment to be added to the discussion, but their is a more exciting story at NAFA you could tell for your readers. The article you wrote is tired, old and not accurate. The only people telling it are the ones who earn their living from wall street. Good luck, I mean it, but the times they are a changing.GHL

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