These days investors are looking for safety and security more than ever, especially after the two major stock market corrections in the last decade.
Years later, numerous brokerage and variable annuity accounts still have not recovered their losses from that time period. Unfortunately, many investors were counting on those funds to provide income and stability during retirement.
Designed to provide a greater return than a traditional fixed annuity, an equity indexed annuity can be a reliable alternative to a brokerage account. Several billion dollars have been deposited into these types of accounts as investors seek safety and the potential for above-average returns.
Investors should have a little background information if they are unfamiliar with annuities. Generally, an annuity functions in the following manner: The investor (usually called the annuitant or owner) agrees to deposit funds with an insurance company for a specified period of time, say 7 years.
The annuity is said to be in deferral during that period of time. While in deferral, most annuities will allow for distributions of interest gains, a yearly 10% free withdrawal, and/or the required minimum distributions mandated by the I.R.S. (Many annuities allow for larger distributions if the owner is confined to a nursing home or is terminally ill.)
Another way to distribute annuity dollars is through a systematic withdrawal (referred to as an annuitization) and it is based on a agreed upon schedule, say 5 years, but can be setup for a lifetime.
If the owner decides to withdraw the entire contract as a lump sum before the annuity has matured, then penalties are accessed based on the surrender schedule in the annuity contract. If the investor passes away, the lump sum of the annuity is paid to a beneficiary at passing unless other arrangements have been made.
Technically, equity indexed annuities are characterized as fixed annuities by the various Departments of Insurance around the country. That is to say, at no point does the investor ever own any variable type of security like a stock, bond or mutual fund within the EIA account. These accounts do not fluctuate in value like a variable annuity. Yet, an equity indexed annuity is not like your typical fixed annuity either.
What makes EIAs different than a traditional fixed annuity is in the way interest is credited to the account. Typically, the insurance company will buy an option in a chosen index like the DOW, S&P 500 or the NASDAQ. After a period of time, usually one year, the option contract comes due.
One of two things will then occur. If the market index has advanced, the option is cashed in and interest is credited to the annuity principal. Conversely, if the market has retreated, the option expires and no interest is credited to the account for that year.
In practice, the annuity either gains or maintains value each year, but the investment cannot lose value due to negative market fluctuations. In this way, the investor is only risking their interest gains in any given year, but in no way is s/he exposing their principal or gains from years past to any downside risk.
It is also important to note that all EIAs have a minimum guarantee each year. For example, this guarantee might state that if the market declines every year over the life of the annuity, the insurance company will guarantee an interest payment of 2% on 90% of the premium deposited for example. However, it is practically unheard of for this safety feature to kick-in as rates or return normally far surpass these guarantees.
Investors should also know that most equity-indexed annuities have a fixed interest account as an additional investment option. When interest rates are high and the stock market is in decline, the fixed account might be used to credit interest to the annuity principal.
In practice, the owner can change their investment allocations each year between the indexing and fixed options provided by their chosen account. Owners are not required to choose one account and allocate all of their funds to it each year or for the life of the annuity.
How do these annuities perform? Historically many of these accounts have averaged returns of 7% or better. In years when the broader markets have performed well, so have EIAs.
It is not uncommon for investors to experience interest payments during prosperous years of 10-20% or better. But the crucial value of these accounts is realized during rapid market declines, when the annuity will maintain its principal as well as the interest gains from past years.
These facts may explain the recent popularity of EIAs, especially among retirees looking to preserve a lifetime’s worth of hard work. With the market advancing and declining so rapidly, many consumers are looking for safety and security without having to sacrifice reasonable interest returns.
Granted, indexed annuities will not return 50% in one year, like a fortunate stock pick might, but the peace of mind investors gain knowing their investment cannot decline has many placing a portion of their retirement funds into these safe and reliable accounts.
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