I have received a couple of questions regarding annuities recently, so it seems appropriate to write about them. I have previously written a primer on annuities and also compared annuities with whole life insurance, but today I will focus on a particular type of annuity, the equity indexed annuity (EIA).
Even though they are available through some banks, banks are never the issuer of annuities and hence they are not covered by FDIC insurance. Only insurance companies issue annuities, so it is important to deal with a financially strong company.
Because of the historically low interest rate environment created and maintained by the Fed, the rate on fixed annuities is commensurately low. For example, current rates for five year annuities are 2.7% with a B+ rated company and 2.3% with an A+ rated company. The interest rate factors used to price single premium immediate annuities (SPIAs) and deferred income annuities (DIAs) are similarly low.
The low interest rate environment that we now find ourselves in has left safety conscious investors between a rock and a hard spot. Do they settle for the paltry rates currently available or put their capital at risk in hopes of higher returns?
A somewhat middle ground is available in the form of equity indexed annuities. First introduced in the 1990s, EIAs are fixed annuities that, instead of crediting a predetermined interest rate, credit interest based on an external index, most commonly the S&P 500. So the only difference between fixed annuities and EIAs is the manner in which they credit interest.
Virtually all EIAs provide that if the index is negative, the annuity will not go down in value. That is what makes them so appealing; the chance to participate in index gains while having the principal guaranteed (by the insurance company, not the government).
So while there’s no risk to principle, there is risk that the index could decrease several years in a row, and thus the EIA would earn nothing. That of course is a lesser risk than that of actually being invested in the index during that period.
As these products have evolved over the years, most carriers have introduced guaranteed income riders, whereby, for a fee, the carrier will guarantee a certain level of income at some point in the future. As annuities are first and foremost a retirement vehicle, these riders have been hugely popular.
As with any financial product, there are good ones and not so good ones. The better ones have more than one index to choose from and riders that will increase the retirement income regardless of performance of the underlying annuity.
Inherently, annuities are neither good nor bad. Given the right set of financial circumstances and goals, they can be an effective tool. Used inappropriately, they can cause financial harm.
This is a very basic overview to give you a flavor of how these products work, but they are not simple. EIAs are very complex products with many moving parts and should not be entered into lightly. If you are interested in learning more, please call or email, and thanks for reading.