Equity-indexed annuities (EIAs) are a type of insurance contract where you invest funds now in order to receive a stream of income later. The growth of your money in an equity-indexed annuity is tied to the performance of a stock market index — for example, the S&P 500.
What is an equity-indexed annuity?
Equity-indexed annuities are a specific type of indexed annuity where your funds grow based on the performance of a market index. [1] The terms “equity-indexed annuity,” “fixed index annuity,” and “indexed annuity” are often used interchangeably. The specific terms used depend on the insurance company offering the products.
Can you withdraw money from your annuity?
How does an equity-indexed annuity work?
The parameters insurers use to dictate how your money grows can vary widely, so it’s important to check the details of your specific contract. Below are a few aspects to look out for.
Accumulation period
Like many types of annuities, EIAs have an accumulation period, which begins when you fund the annuity with either a large, lump-sum payment, or a series of smaller payments over time. During this time, your money will gain interest based on the terms set by your insurer and the market index you selected.
Equity-indexed annuities allow you to allocate your money in a fixed account as well as an index-tracking account.
The index tracking account typically offers a 0% floor, so you won’t lose any of your account value.
The fixed interest rate account offers a set rate, determined by the insurer and recalibrated once per year.
For example, if you allocate 50% of your funds in the fixed interest rate account, only those funds would be affected by the guaranteed fixed index rate. The remaining 50% of the funds would earn based on the designated index (but wouldn’t lose beyond the floor of 0%). This reduces your investment risk compared to investing directly in the stock market.
FIAs also have a minimum guarantee value (MGV), or guaranteed minimum surrender value (GMSV), that kicks in if for some reason your account value doesn’t meet the minimum guarantee (which is usually 87.5% of your principal at 1% to 3% interest). [2]
It’s rare for the MGV to come into play, but this feature gives you an additional safeguard if you were to pass away shortly after buying your contract, or if the stock market suffers for multiple consecutive years.
Learn more about other types of annuities
Annuitization or payout period
Usually between three and 10 years later, you’ll enter the annuitization period, which is when you’ll start to receive income payments from your annuity. You can typically select to receive payments on a set schedule, either monthly or annually. How much money you receive with each installment depends on the terms of your contract and how you chose to allocate your funds.
Most often, annuities pay out for the life of the annuitant. You’re guaranteed to receive payments as long as you live, and once you pass away, the payments stop.
You can typically pay extra to have more guarantees — for example, a life with period certain annuity pays out for the life of the annuitant with an added guarantee of a certain number of years (usually 10 to 20). In this case, if the annuitant passes away early, a beneficiary can receive payments for the remainder of the guaranteed period.
Learn more about life only vs. period certain annuities
Participation rates
Participation rates dictate how much interest will be credited to your account relative to the performance of your chosen index. For instance, if the index earned 10% in a specific year, but the participation rate is 80%, then only 8% growth will be credited toward your funds.
Insurers often use participation rates with all kinds of indexed annuities. Make sure to check your contract details for specific information related to your annuity.
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Floors or minimum returns
Indexed annuities — including EIAs — come with floors of 0% in your index-tracking account. This limits the losses if your chosen index underperforms — for instance, even if the index underperforms by 5%, your funds won’t be susceptible to that loss.
What is the impact of interest rate changes on your annuity?
Caps
Your insurer may also set a cap on the interest you earn. Insurers often set these parameters to buffer against loss on their end, since they also offer minimum guarantees to protect you. So if your selected index earns 9% in a given year, and your annuity has a cap of 7%, you’ll only get 7% growth credited toward your funds instead of the full 9%.
Can you lose money in an annuity?
Surrender period & other fees
Like many annuities, EIAs also have surrender periods, which is the amount of time after buying your contract during which you can’t withdraw funds without paying a penalty fee. This fee is called a surrender charge. [3]
Surrender periods often last between three and 10 years, but it depends on the insurer. Many annuities have surrender periods with fees that decrease over time, where you’d pay more for making an early withdrawal in year one than you would in year three.
Insurers may also charge administration fees, which can further detract from your credited returns. You may see these fees called “spread,” “margin,” or “asset” fees in your contract.
Many annuities can have both participation rates and caps, which, combined with fees, can reduce the accumulated value of your contract significantly. Before you purchase your annuity, make sure to meet with a financial expert who can help you understand all the terms and fees included in your contract.
Learn more about how annuities work
Tax implications
Similar to other types of annuities, equity-indexed annuities earn interest on a tax-deferred basis. You won’t pay taxes on any earnings you put into the annuity until you begin receiving income payments. However, you will face a tax penalty if you make early withdrawals before age 59 ½.
If you fund your EIA with post-tax dollars (also called non-qualified funds that have already been taxed), you’ll only pay taxes on the interest earned when you begin receiving income payments, rather than taxes on both the principal and the interest.
By contrast, if you fund your annuity with pre-tax dollars (also called qualified funds) — for example, with money from a 401(k) or an IRA — you’ll pay taxes on the principal and the interest when you start taking withdrawals. [4]
Learn more about qualified annuities
What are the pros & cons of equity-indexed annuities (EIAs)?
“Since EIAs track market indexes, owners can participate in some of the market’s upside if the market performs well,” says Shawn Dye, senior manager of product marketing at Zinnia. Plus, EIAs typically come with minimum guarantees. However, your funds are still subject to some market volatility, and you don’t know exactly how much interest you’ll earn.
Pros
Higher earning potential. You could earn more from an EIA than you would with a fixed annuity, but it depends on market performance.
Tax deferral. Like other types of annuities, you won’t need to pay taxes on the interest earned until you start making withdrawals during the payout phase.
Protection against inflation. Your money has a chance to grow alongside inflation, as opposed to earning interest with a fixed annuity or multi-year guaranteed annuity (MYGA) that remains at a set rate.
Cons
Some investment risk. EIAs may only guarantee your principal up to a certain percentage (for instance, 87.5%), so you do take on some investment risk, and you could lose some money.
Fees and penalties. Equity-indexed annuities can come with commissions, surrender fees, and other administrative costs that can subtract from your earnings.
Caps and participation rates could limit earnings. Even when the market is performing well, your earnings could be limited by caps set by your insurer.
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What should you consider before buying an equity-indexed annuity?
Each EIA will have different guidelines regarding caps, floors, fees, and how interest is credited toward your account, so it’s important to read the fine print of your contract. Here are a few other considerations to take into account while considering this type of annuity.
Your age
Equity-indexed annuities are primarily used as long-term investment tools, so if you need an additional income stream sooner rather than later, you might want to consider an immediate annuity instead.
Your investment goals
As mentioned above, EIAs can complement your long-term investment goals, but you’ll need to check that the terms of your specific contract align with your plans. If you’re comfortable with some investment risk, but you still want a minimum guarantee, an EIA could be a good fit.
Your risk tolerance
EIAs do require some investment risk, but you'll at least know how much you might earn or lose thanks to minimum guarantees.
If you have a low risk tolerance and you want more guarantees, you may consider a different type of annuity, like a fixed annuity. If you have an even higher risk tolerance and you’re comfortable with even more market volatility, you could consider a variable annuity.
Are annuities a good investment?
Who should consider equity-indexed annuities?
Equity-indexed annuities “might be better for someone who is more risk-averse and looking for some growth potential with a guaranteed minimum return,” says Dye of Zinnia.
When buying any kind of indexed annuity, it’s important to take a holistic look at your financial plan. If you’re comfortable with interest rate fluctuations and you’re looking to earn interest tax-deferred, you can consider an EIA. A financial advisor or annuities professional can help you understand the terms of your contract and determine if an equity-indexed annuity is right for you.
How does an annuity fit into your overall retirement plan?
