An equity-indexed annuity (EIA), like any annuity, is a contract between you and an insurance company. You pay premiums in a lump sum or periodically, and the issuer promises* to pay you some amount in the future. With an EIA, that amount is tied to the performance of an equity index. The EIA issuer also promises* that even if the index declines, the interest rate on your annuity will not fall below a minimum guarantee (typically 3%). You get the opportunity to gain if the market performs well, and you also get the comfort of knowing your return will not fall below the specified minimum if the market performs poorly, as long as you hold on to your annuity for the entire term. An EIA may be a good alternative if you want an annuity that has the potential to earn a higher rate of interest than a fixed annuity, but is less risky than a variable annuity.

Basics

The first EIAs that were introduced worked very simply; the interest rate was determined by computing the difference between the value of the index to which the annuity was linked on the annuity's issue date and the value of the same index on the annuity's maturity date. If the difference was negative (i.e., the market performed poorly and the value of the index decreased), interest was calculated using the minimum rate guaranteed* by the issuer. If the difference was positive (i.e., the market performed well and the value of the index increased), the interest rate used was a percentage of the difference--but usually not the entire difference.

Participation rates

The participation rate determines how much of the gain in an index will be imparted to your annuity. For example, if the difference (i.e., gain) in the index is 7% and the participation rate is 90%, then the interest rate is 6.3% (90% of 7%). Participation rates of 70% to 90% are typical. Obviously, the higher the participation rate, the higher the return. However, EIAs have many features, some of which can offset a lower participation rate or other features. Keep this in mind when considering an EIA or making comparisons between EIAs.

Indexing methods

The indexing method is the approach used to measure the change in an index. The original method, which measures index values at the beginning and end of the term, is known as the point-to-point or European method. Still used today, the point-to-point method is the simplest approach, but it fails to consider market fluctuations that occur in between the issue and maturity dates. This can result in unsatisfactory returns if the market declines at the end of the term. Another approach, known as the high-water-mark or look-back method, looks at the value of the index at certain points during the term, such as annual anniversaries. The highest value of these points is then used to compute the difference from the date-of-issue value. A third approach, the averaging method, also looks at the value of the index at certain points during the annuity's term, then uses the average value of these points to compute the difference from either the date-of-issue value or the date-of-maturity value.

The fourth main indexing method is known as the reset or ratcheting method. With this method, start-of-year values are compared to end-of-year values for each year of the annuity's term. Decreases in the index are ignored, and increases are locked in every year.

How interest is credited to an EIA

With some EIAs, no interest is credited until the end of the term. With others, a percentage of the interest is vested or credited annually or periodically, which gradually increases as the end of the term nears. Further, some EIAs pay simple interest while others pay compound interest. These features are important not only because they affect the amount of your return, but also because having interest vested or credited to your EIA periodically instead of at the end of the term increases the likelihood that you'll receive at least some interest if you surrender your EIA before maturity.

Caution: Many EIAs have surrender charges, which can be a percentage of the amount withdrawn or a reduction in the interest rate. Further, withdrawals from tax-deferred annuities before age 59½ may be subject to a 10% penalty.

Interest rate cap

Some EIAs put an upper limit on the interest rate the annuity will earn. Say, for example, that an EIA has an interest rate cap of 6%. If the gain in the index is 7% and the participation rate is 90%, the interest rate will be 6%--not 6.3%.

Asset fee/spread/margin

Some EIAs charge an asset fee, also known as spread or margin, which is a percentage that is deducted from the interest rate. The asset fee may replace the participation rate or it may be added to it. For example, if the gain in the index is 7%, the interest rate on an EIA with an asset fee of 2% will be 5%. If there is also a 90% participation rate, the interest rate will be 4.5%.

Tip: All of an EIA's features should be clearly spelled out in the prospectus or other sales literature, and if you purchase the EIA, in your contract as well.