Grow Money in an Equity-indexed Annuity

Physician's Money DigestJanuary 2006
Volume 13
Issue 1

Excellent alternatives forinvestors seeking safety ina low interest rate environmentor a volatile market,equity-indexed annuitieswork by basing your return on theincrease of a stock or equity index, suchas the S&P 500. If stocks rise, you benefitfrom the increase. If stocks fall, youdo not lose money. Because most contractsguarantee a minimum return,typically 3%, this newer product isespecially attractive for retired personsand those approaching retirement.

Exchange for Safety

Obviously, there is no such thingas a free lunch. The issuing insurancecompany guarantees a minimum return,principal value, and prior earnings,subject to their claims-paying ability,when held to the end of term. Inreturn for this protection, the companylimits the maximum returns an investorcan receive from a rising market,depending on the particular indexingmethod that the annuity company uses.

The most common method used tolimit returns is called a participationrate. For example, the insurance companymay set the participation at 90%(some companies are as low as 50%),which means the annuity would becredited with 90% of the growth experiencedby the index. If the indexgained 10%, then your gain would be9% for that year. Essentially, you aretrading 100% of the market risk toreceive a share of the market gain.

In addition to the different participationoptions, there are index annuitiesthat use an annual reset methodfor crediting index-linked interest. Thisvaluable method allows you to lock ingains permanently in an up market. Involatile markets where the index declines,the annuity simply resets, lockingyou in at the lower index level. Infact, some index annuity renewalshave been reset at very attractive levels.The lower the reset, the more opportunitythere is for future growth.

Annual Reset Returns

Let's take a look at a prolonged bearmarket and see how an equity-indexedannuity would have performed utilizingthe annual reset method. In the1973 to 1974 downturn, stock pricesfell more than 40%. The S&P 500closed at an all-time high toward theend of 1972, and it wasn't until 1980that these levels were retraced. So, ifyou bought at year-end in 1972, itwould have taken about 7 years tobreak even using the traditional buy-and-hold technique. Utilizing a 90%participation equity-indexed annuitywith the annual reset method from1972 to 1979 would have resulted in areturn during those 7 years of approximately70%—even though the indexhad not yet returned to its former high.

Equity-indexed annuities are long-terminvestments that are subject topossible surrender charges and a 10%penalty from the IRS for withdrawalprior to age 591/2. Risks include inflationand default risk. Due to the complexityof equity-indexed annuities, Iwould strongly suggest you consultwith a knowledgeable investmentadvisor to see how they might fit intoyour financial plan.

Robert Valentine offers financial and retirement management services with Securities America Inc in Huntington

Beach, Calif. His financial planning articles have appeared

in several publications. He welcomes questions or comments

at 714-962-1800.

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