Comparing Equity Indexed Annuities

Equity indexed annuities are the new darling of the financial planning industry. Since their introduction in 1995, they have continually grown in popularity. And with fixed yields still near historic lows, and the stock market still giving investors fits, they are emerging as the go-to annuity for retirement savers. But, just as fixed annuities and variable annuities proliferated during their periods of popularity, the number of equity indexed annuities have swelled which makes it all the more difficult to know which ones offer the best opportunity for solid, long-term performance. Comparing equity indexed annuities can be somewhat perplexing unless you know the specific criteria for evaluating them.

Key Points of Comparison

The most effective way to evaluate equity indexed annuities is to focus on the key components that drive their performance: The participation rate, the cap rate, the floor rate, the length of the surrender period, and the company’s renewal rate history.

Participation Rate

The yield credited in an equity indexed annuity is tied directly to the percentage gain of a corresponding index, such as the S&P 500. But, the actual yield that is credited is based on the stated participation rate which can range from 50% to 100%. The higher the participation rate is, the higher the portion of the index gain your account will receive as a credit. So, if the index gains 20%, and the participation rate is 100%, your account will be credited with 20%. Lower participation rates are not necessarily a bad thing if they are guaranteed for a longer period of time. If an annuity offers a high participation rate, it is likely to have shorter and more frequent rate renewal periods which means you could end up with a much lower participation rate at some point in the future.

Performance Cap Rate

After your participation level is determined, the annuity provider will apply a cap rate which can further limit the amount of the index gain that is credited to your account. So, using the previous example, if the participation rate is 100% resulting in a 20% yield credit, a 10% cap rate would limit the credit to 10%. The cap rate is a mechanism used by the annuity provider to ensure that they generate revenue for their own account, and it also provides them with a cushion to cover their losses when they apply a minimum floor rate in a down market.

Essentially, the cap rate becomes your principal protection device. Regardless, you will want to look for annuities with higher cap rates, or no cap rate at all. As with the participation rate, you will want to consider the rate renewal terms of the contract to avoid being lured in with a high initial cap rate only to have it lowered in the future. Also, it is not uncommon to find an annuity with a high cap rate that has high expenses as a way to recoup the lost revenue.

Floor Rate

One of the distinguishing features of an equity index annuity is the downside protection it provided during declining markets. This is achieved through a floor rate or minimum rate guarantee. Obviously, the higher the floor rate, the better your annuity may perform over time should the index encounter persistent market declines.

Surrender Period

Most people who invest in annuities do so with a long term horizon and with sufficient liquidity in other parts of their portfolio, so the withdrawal provisions are usually of little concern to them. Still, you may want to consider how much flexibility your annuity has in accessing funds should you need them. Most annuities allow you to withdrawn 10% of your account value without charges. However, excess withdrawals made during the surrender period will incur a surrender fee. The fee, which can start as high as 15% in the first year of the surrender period, declines by a point each year until it vanishes all together.

Regardless of how concerned you are with accessing your funds, you may want to consider those annuities with shorter surrender periods. However, equity indexed annuities that offer more competitive participation and cap rates tend to have longer surrender periods. So, if you have little or no concern over getting access to your funds, you could benefit from annuities with higher rates.

Renewal Rate History

With most equity indexed annuity contracts, the annuity provider has the ability to change the key rates on the contract’s anniversary. For instance, it could reduce your participation rate. Or, if there was, initially, no cap rate, it could introduce one. It would be important to look for contracts that have extended guarantee periods for these rates, but, where there are none, it is then important to consider the providers history on rate renewals to see how frequently or how greatly they adjust the rates. This is why it is important to only consider providers who have established track records with equity indexed annuities.

Company Strength

Unlike variable annuities in which your funds are invested in separate accounts, the funds of equity indexed annuities are invested in the general account of the issuing life insurance company. While life insurers are heavily regulated in the manner in which they can invest your funds, and they generally tend to be very conservative in their approach, it would very important to work with those companies that have a demonstrative record of safety and sound management. Companies that are rated highly by the independent ratings firms are considered to have superior financial management capabilities and a much stronger outlook during shaky economic periods.