FPA Financial Planning Perspectives
SHOULD YOU CONSIDER
EQUITY-INDEXED ANNUITIES?
Would you invest in a product that lets you participate in stock market gains but protects you against market declines? That’s the promise of equity-indexed annuities, and considering the state of the stock market these past three years, it’s a tempting promise. But equity indexed annuities are complicated, with many variations, and they’re not right for everyone.
Equity-indexed annuities are a hybrid of fixed and variable annuities. Fixed annuities pay a set fixed rate, while the return of variable annuities depends entirely on the returns of the mutual-fund-type sub-accounts in which you invest, meaning you could lose or gain money. Equity-indexed annuities guarantee to protect your principal, and in some annuities even past market gains. They also guarantee a minimum return—typically around three percent—even if the stock market declines. On top of these guarantees, the index annuity gives you the chance to earn significantly above the minimum rate if the index the annuity is pegged to gains in value during a specific time period. The S&P 500 index is the most commonly used index, but there are several others, including fixed-income indexes.
Like other forms of annuities, index annuity earnings are tax deferred and the annuity carries surrender charges, meaning you’ll pay a penalty if you cash out the annuity before it matures. (Many annuities allow annual withdrawals of up to ten percent of the value of the annuity free of penalty.) Maturities vary, but the large majority of indexed annuities tie up your money for ten years. Planners advise that you don’t buy an annuity whose maturity date is later than when you will need the funds.
Sounds like the best of both worlds, doesn’t it? But here’s where it gets complicated, and where the details can make a difference in whether buying an index annuity is a good idea for a particular investor.
Index annuities have two major components: the percentage of the gains you can capture, called the participation rate, and exactly how those gains are calculated. First, a contract might set a participation rate for the length of the contract—70 percent to 90 percent is the typical range, though it can be lower or higher for some contracts. Furthermore, some participation rates change annually. Thus, if the index gains 15 percent in value, you might earn 10.5 percent to 13.5 percent of the gain.
On the other hand, some contracts set caps (which also can change). For example, your participation rate might be 90 percent and the gain is 20 percent, but the cap might cut you off at 10 percent. Also be aware that you receive only a percentage of the index gain—dividends are not included. Many investors don’t realize that dividends account for a substantial portion of stocks’ total return. For example, dividends accounted for 40 percent of the total return of the S&P 500 from 1926 to 2001, according to Ibbotson Associates.
The second major component is how the gain from the index is calculated. There are several methods. For example, the “point to point” method calculates the gain based on the value of the index at the start of the investment and at the date of maturity. Consequently, if the market happens to take a big hit right at the end of your ten-year term, for example, your gain will be significantly reduced.
Another method is to average several points along the way. Some look at the price on each anniversary date of the contract and pick the highest one as the level for the maturity date. Others credit a portion of each year’s gain.
Which method is best? That will depend largely on how the market moves during the contract period. Certain methods provide better results in highly volatile markets than markets that climb steadily. That’s why it’s important to talk with your financial planner so that you thoroughly understand how a particular index annuity works.
The other question, of course, is whether an equity-index annuity is even right for you. For example, investing through mutual funds and individual securities allows you to capture the full total return (including reinvested dividends), though of course with risk of loss of principal. You’ll need to compare costs and tax issues, as well, to see what type of investment approach is best for your personal circumstances.
April 2003— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Rich Chambers, CFP®, a local member in good standing of the FPA.
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