Fixed index annuitySeveral years ago while tuning into Dateline on NBC, I watched as they conducted one of their typical undercover operations.

This one was a bit different though and more closer to home as they were running sting operations on financial advisors.

To be clearer, it was more on independent life insurance agents that were pitching equity indexed annuities to seniors.

At the time I had only been in the business for around four years, and while I was familiar with fixed annuities and variable annuities, I didn’t quite understand what equity indexed annuities were all about.

The gist of the Dateline Special was showing how crooked financial advisors (aka advisors I would like to punch in the face) were using every sales tactic possible to try to generate a sale, otherwise known as a big fat commission.

While I have no problem with anybody trying to earn a living, I do have a problem with someone trying to line their pockets while putting some else’s best interest out of sight.   And that’s what these advisors were doing, selling equity indexed annuities while not conveying the whole truth.

At that point in time I got a really bad taste from equity indexed annuities. I have to confess, I still didn’t know much about them, though with Dateline promoting them as the worst investment product ever made, I decided it would be in my best interest to stay away.

Note: I want to stress here that these advisors weren’t selling an inferior product.  In the right situation, Equity Index Annuities can make sense.   In the Dateline sting situations, these advisors were not being truthful with how these products really worked.

In the market collapse of 2008, equity indexed annuities have become much more popular.

I’ve talked to several individuals that have purchased them merely for the fact that they are fed with the stock market.

They are looking for a guarantee and don’t mind locking up their money for an extended period of time while also taking a lower interest rate in exchange for less risk and volatility.

Knowing that I should be versed on how these products worked, I knew that I should start doing some research.

Sharing the Basics

With this post I wanted to share some of the basics of how an equity indexed annuity works and to see if it might be a good investment for you.

I also have a loyal Good Financial Cents reader who is a big fan of equity indexed annuities, and I’ve asked him to share his reasoning on why he purchased them for his own retirement planning (he’ll be sharing in the comments).

 What is a Fixed or Equity Indexed Annuity?

Good question.

Like all other annuities, an equity indexed annuity is a contract between you and the insurance company where they guarantee some sort of payment.

Essentially, a equity indexed annuity (sometimes referred to as EIA’s) is sorta of a hybrid between a standard fixed annuity and a variable annuity.   I say “sorta” because while do have similar characteristics, there are significant differences.    According to FINRA’s website, they describe them as the following:

“EIAs are complex financial instruments that have characteristics of both fixed and variable annuities. Their return varies more than a fixed annuity, but not as much as a variable annuity. So EIAs give you more risk (but more potential return) than a fixed annuity but less risk (and less potential return) than a variable annuity. EIAs offer a minimum guaranteed interest rate combined with an interest rate linked to a market index. Because of the guaranteed interest rate, EIAs have less market risk than variable annuities. EIAs also have the potential to earn returns better than traditional fixed annuities when the stock market is rising.”

There’s no doubt that equity index annuities are confusing.   When variable annuities started offering their income benefit riders (these are special add-ons that annuity products offer to give investors a guaranteed income stream), I became overwhelmed with all the mechanics behind them because every insurance company had something slightly different.   To compound the problem, they were constantly making small tweaks to their offerings making it difficult to sort out which one was which.

Now imagine if it’s difficult for the advisor to understand how these products work, how do you think the clients feel?  Exactly.

To best understand how these annuities work, I thought it would be best to break it down into two parts.   The first part we’ll look at is the index option and explain how that works.  The second part we’ll explore the “income rider” or “guaranteed benefit withdrawal” that most of these products offer.   This income rider is one of the major selling points for most individuals so I definitely want to take a closer look at that.

How a Equity Indexed Annuity Works

How a Fixed Indexed Annuity WorksA common selling point in regard to fixed indexed annuities is the guarantee of principal {meaning that you will never lose a dime of your money that you pay to it}.

While yes that is certainly the case, one thing that you need to be aware of is that all annuities come with some form of surrender charge meaning that if you were to cash out your annuities early, you would pay a significant surrender just to get your principal back. (We’ll look at a sample surrender schedule so that you can see exactly how much you would pay in penalties.)

Going back to the original point, yes your principal is guaranteed so as long as you keep the annuity for the entire length of the contract.  As you can imagine, for many investors that scorn the stock market this is a valuable characteristic to have.

How does the index option work? 

For the sake of this post, I want to keep it very simple and just explore one of the indexed options that are currently available.  Please keep in mind that all indexed annuities have various indexed options and various cap strategies so understanding what you’re actually getting into is essential.

In this scenario that I have a screen shot of it shows investing $250,000 into an equity indexed annuity.  This particular annuity has a ten-year contract period and is currently using a basic indexed option known as the S & P 500 point-to-point index strategy.  The S&P 500 index strategy is probably the most common index that you will see used in any of the equity indexed annuity products.

I’m starting to see more now use international indexes, other market indexes such as the value index and I’ve even seen some now use a gold index.

Equity Index Annuity Illustration

Sample. For illustrative purposes only

In this illustration since we are taking on a ten-year contract, the investor is entitled to a bit of a higher cap on the interest rate.

For example, in this case the election of interest credit is 3.5% (usually referred to as the “cap rate”).  With the rates being at all-time lows, these cap credits are significantly lower than they were in years past.  With this same product, had the investor taken out a five-year product they would’ve been capped at 3% instead of 3.5%.  Most insurance companies will give you a higher rate if you lock up your money longer.

So how does the interest rate cap work?  Looking at the illustration in year one if an individual was to put $250,000 in and the S&P 500 index performed 7.43%,  the investor would get a cap of 3.5% credited to your account. The remaining difference goes back to the insurance company.  If there is a “catch” in these type of policies, that would be the big one.

In year 2, the illustration shows the the S&P 500 going up 5.35%.  Once again you’re capped at 3.5% with the remaining difference going back to the insurance company.

At this point you’re probably wondering why in the heck you would want to be capped on your upside?  Looking at year 9 should put that into perspective for you.

In year 9, when the S&P 500 is down 9.25%, in that year you don’t make the 3.5%, but most importantly you don’t lose anything showing a net return of zero.  That’s one of the attractive features of the equity index annuities.

With equity index annuities, your principal is protected in years the market loses money no matter how steep the losses.

Quick note, personally I’m not a big fan of these types of illustrations.  Why?  Primarily because in the first couple of years they usually show constant growth and as we all know, the market does not work in that way.  We have ups and downs.  Personally, I would like to see an illustration that shows losses in the beginning to not give the potential investor high hopes in their expected returns.

 Surrender Charges Beware!

In the Dateline special that I watched several years ago, one of the main things that they focused on was the disclosure of surrender charges when it came to equity indexed annuities.  A lot of the bad advisors were very misleading or deceptive when sharing if there was, in fact, a surrender charge.  In one case, one independent insurance agent flat out lied to the potential client telling them that they could withdraw their money at any time.  This is far from it.

The first thing that you have to realize that equity indexed annuities come in different contract lengths.  They can be anywhere from four years on up to 15 years.  I’ve seen them all.

In the illustration above, this was a ten-year contract.  I’ve enclosed a snapshot of the surrender schedule that you would be included in the documentation for the illustration above.  As you can see, in the first year if you were to liquidate the annuity, there would be a 10% penalty on your interest and principal.  This is very important to note.

Equity Index Annuity Surrender Charge

Sample Surrender Schedule


Often times, bad advisors will sell these to seniors comparing them to CDs in their security and stability.  While the one big fundamental difference is that with the CD, if you cash it out early, you just give up your interest.  A fixed indexed annuity, if you surrender it early, not only do you give up your interest, but you also give up a portion of your principal, and that is a huge difference.

Now keep in mind, most of these annuities do allow for a free withdrawal, meaning that you can withdraw anywhere between 10% to 15% of your principal each year without a surrender charge, but anything over and above that will be subject to the surrender schedule.

Where Equity Index Annuities Really Flourish – Income Riders

Thus far we looked at the cap rates and principal protection that EIA’s offer.   For some people (especially retirees) that’s enticing, but it might not be enough for them to invest into one.  Where many retirees find comfort in EIA’s is there income riders.

How the income riders work.    Sticking with our $250,000 example above, I’ll demonstrate how the income rider works.

Say that a 60 year old invests $250,000 into an EIA and wants to start taking a guaranteed monthly benefit, then using the table below, they would have a $10,000 ($250,000 x 4%) guaranteed annual income for life.  Even if they end up pulling out more than their principal, they would still continue to receive payments.

A 65 year-old individual with the same amount would get a bit more collecting $12,500 guaranteed per year.

Equity Index Annuity Income Benefit Withdrawal Schedule

Guarantees for retirement

Where income riders get even sweeter.  If you’re a 60 year-old individual that has $250,000 to invest but doesn’t plan on retiring until 65 or later, then the income benefit riders becomes that much more attractive.   Insurance companies will give an additional credit to the income account that, in turn, gives you a potential higher payout when you need it.   Let me explain……

A 60-year old may get a 5% income credit increase each year up until the day they decide to start taking their money.    That means that the insurance company will add 5% a year to original deposit (in this case $250k) each year.   Once you start taking your income, the payout will be the amount in your income account multiplied by the withdrawal percentage based on your age.

The table below illustrates this over a 10 year period.

Years DeferredAgeIncome Account ValueAnnual Payment
565$319,070.38 (5% payout begins)$15,955.51

The 5% income credit is for hypothetical purposes.  Each insurance company will have their own set interest rate.  Recently, I’ve seen anywhere from 5% all the way up to 7%.

Another thing to consider is that the maximum withdrawal percentage is typically lower if you’re looking for a lifetime guarantee for you and your spouse.  Typically, it will be about .50% lower.

Beware:  The income credit and the maximum withdrawal percentage are used to determine your payout guaranteed payout.   It is NOT the same thing as “making 5% on a CD”.   I’ve encountered many advisors that sell these as investments with a “5% guaranteed return”.

Yes, there is a guarantee but most people associate that return like a CD or a bond would pay.  These are two totally different animals.  If an advisor presents this to you as a “CD like investment” I would be cautious.   Very cautious.

Who Should Buy a Fixed or Equity Index Annuity?

So with all that thorough analysis, you’re probably wondering for whom does it make sense to purchase an equity indexed annuity.  Typically I think if you meet some of the following criteria, then you might be a good candidate.

  1. You absolutely hate the stock market.  If you’re tired of seeing your investments rise and fall with the Dow Jones, then an equity indexed annuity might be a good fit.
  2. If you have five to ten years before you actually need to draw income.  Personally I think the income riders are a viable option for those that want to avoid the market and want to have a guaranteed income stream at retirement.  With the income account increasing each year for each year that you’re not touching it, this can be a huge benefit for someone who has a big chunk of money that can invest it and sit on it for a few years.
  3. You want to diversify. You might be a strong believer in the markets, but a little certainty never hurt anyone.   Taking some money and locking it up in annuity with a guaranteed income rider could make sense.

As always, make sure that you ask plenty of questions and make sure you have a solid understanding before many any investment.  Annuities are long-term investments so don’t use this if you’re looking for a short-term solution.

Have you purchased an equity indexed annuity?  What was your experience?




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Comments | 10 Responses

  1. Roy says

    Good article. Had the concept of the Indexed Annuity with the income rider been properly explained to me, I might have well considered one for a portion of my portfolio, say that 250K, but it would have needed to cover both myself (probably not long lived based on family history), and the wife, should run til mid 80’s based on family history).

    Biggest variant seems to be the competency of the agents.

  2. says

    What a good article!

    I am a strong believer in Equity Indexed Annuities. In fact, most of my retirement funds are invested in them. What appeals to me most is that I don’t ever have to worry about my savings again. It used to drive me crazy to see the value of my stocks and bonds going up and down. Now, if stocks go up, fine…but, if they go down, I don’t really care, since I have the Income Riders that ensure me of a competitive rate of growth, regardless of what happens to the indexes. Equity Indexed Annuities provide a combination of growth potential, very little risk, and the benefits of lifetime income. Equity Indexed Annuities are going to provide me with the worry-free retirement I want.

    However, anyone contemplating Equity Indexed Annuities with Income Riders should be aware of the following caveats:

    1) Most Income Riders stop when you start annuitizing. That means if you have a 7% income rider, you will only get that increase during the accumulation phase and not when distribution starts. That means you might get the increase for 10 years, but not after that, when the annuity reverts to being an Immediate Annuity and you get the same payment every year for the rest of your life.

    2) Most Equity Indexed Annuities don’t have inflation protection, so what might seem like a good deal today (with2% inflation) might not be so good if there is hyperinflation (due to the inevitable consequences of debt and money printing).
    3) Any annuity is only as good as the insurance company backing it up. So make sure you check the ratings. And remember that an “B” might be a decent grade in school, but it doesn’t necessarily reflect a solid insurance company!

    Whatever you do, make sure you have a good Income Plan that will ensure that you have sufficient income in retirement, for as long as you expect to live. Also, make sure you factor in the potential for inflation. But, that said, if you are looking for a way to ensure a lifetime income, regardless of what the market does, then Equity Indexed Annuities might be right for you. If you are a worry-wart like me, you will certainly sleep better at night.

  3. Christie Hartshorn says

    Deciding which type of annuity to buy can often be really tough. To be able to have the most from your investment, make sure to know what kind of annuity you have and what it is the intention of this investment.

    • Dean R. Spitzer, Ph.D. says

      Christie is making a good point. There are many different types of annuities: immediate and deferred (fixed, variable, equity-indexed). As I see, it equity-indexed annuities include the features of the others: a fixed guaranteed rate (income rider), a variable opportunity (participation in the index), and ultimately the longevity bonus of the immediate annuity.

  4. Dean R. Spitzer, Ph.D. says

    Jeff…We know that equity indexed annuities provide predictable guaranteed growth. However, perhaps some of your readers might have the same question as I do: When you give your money to an insurance company for a long period of time (at least 10 years to avoid the high surrender charges) at 5-7% income rider (aside from the indexing), how concerned should we be able losing control of our assets in the face of the government’s debasing our currency (resulting in potentially serious devaluation and inflationary conditions)? Is there any strategy you would suggest to reduce or manage that risk?

    • says

      @ Dean

      It’s hard to speculate what could happen over the next 10 years. Any strategy that sounds great now could be obsolete or at least less attractive 3, 5, or 10 years down the road.

      Annuities (with income riders), are a good fit for those that are fairly certain that the income they generate is more than enough to cover the monthly expenses with some cushion. But you better have some cash on reserves, too!

      • Dean R. Spitzer, Ph.D. says

        Jeff…You are so right. And you did provide some valuable suggestions on short-term savings in a low interest-rate environment in a recent post. Thank you!

  5. says

    As I see it, with equity indexed annuties, you’re trading a lower risk for a lower return. Fair enough — but if that’s your goal, why not balance your equity portfolio with high-quality short-term bonds? The risk reduction goal is reached with a commensurate reduction in returns, but without having to worry about surrender charges (or any other charges). Also, you can diversify your risk with the short-term bonds, but with the annuity, you’re banking on the insurance company not going under. A small risk, to be sure, but a nonzero one, as AIG will attest.

    Also, I believe Larry Swedroe has done a study on equity-indexed annuities, and shown the reduction in return is far greater than it should be for the reduction in risk. Essentially, you’re paying extra for the comfort of never ever seeing your portfolio returns go negative.

    I’d be interested to hear the counter-argument, though.

  6. Dean R. Spitzer, Ph.D. says

    Gregory…I will be interested in how Jeff responds to your post. I guess you are right about Equity-Indexed Annuities, from a purely financial perspective. For me, it is not just the security. I like not having to even think about my investments (It’s like putting my investments on auto-pilot) and the business climate. Also, from a planning perspective, I now how how much money I will have for each year of my retirement.
    As for your comment about AIG, its consumer insurance company never needed a bail-out; it was the derivatives business that did.

    • says

      Re: AIG, you may have to fill me in on the details — I was not aware that they were two separate companies, and thought they were merely two divisions of the same company. So if the derivatives side had not been bailed out, the consumer insurance side would still have been intact? This seems odd to me, as my understanding is that it’s the profits from the investing side that fuel the insurance side.

      But I’m nitpicking, there. The point is that insurance companies are not infallible, and that one must be wary.

      However, your second point is well-made — putting your investments on autopilot can be worth a chunk of change. My question is this: what’s the advantage of choosing an equity-indexed annuity over either (a) reasonable fee-only financial planner or (b) an immediate fixed annuity? With the former, you can get “autopilot” without having to lock up your money (and hopefully can design in better inflation protection), and with the latter, you know exactly what you’ll be getting each year (and that there will always be gains). Is it supposed to be a “happy medium”? And if so, at what cost?

      I dug up the chapter by Swedroe on EIA’s in his book on alternative investments, and it doesn’t paint a pretty picture. He points out half a dozen ways that providers reduce the return from the index, from the aforementioned caps to not including dividend returns and playing other funny games with the calculations. Not to mention something I’d forgotten: the fact that it turns capital gains taxes into ordinary income taxes. In his summary, he quotes a research paper written a few years back:

      “In 2006, Dengpan Luo and Craig McCann coauthored a paper on EIAs. They found that an astounding 15 to 20 percent of the premium paid by investors purchasing EIAs represented a transfer of wealth from unsophisticated investors to insurance companies and their sales forces. They concluded, “Insurance companies add trivial insurance benefits, disadvantageous tax treatment and exorbitant costs to mutual funds and sell them as equity-indexed annuities.'”

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