Investors seem to be looking for safety and security more than ever these days, especially after the major stock market correction that occurred from 1999 to 2002. Four years later, many brokerage and variable annuity accounts have yet to recovered its losses for that period. Unfortunately, many investors relied on those funds to generate income during their retirements.

Hence, the introduction of the equity-indexed annuity, or EIA, to the mainstream market. Designed to provide a higher return than a traditional fixed annuity, the stock-indexed annuity can be a reliable alternative to a brokerage account. At just fifteen years old, several billion dollars have been deposited into these accounts.

Annuities in General

First, a potential investor should have little background information. In general, an annuity works like this: The investor, usually called the annuity owner or beneficiary, agrees to deposit funds with an insurance company for a specified period of time, say 7 years. The annuity is said to be deferred during that time period. While deferred, most annuities will allow partial distributions of interest earnings or an annual free withdrawal of 10% or the IRS-mandated minimum distribution (Many annuities allow larger distributions if the owner is confined to a nursing home or is terminally ill.) Yet another way to distribute annuity dollars is through a systematic withdrawal, known as annuitization, based on a predetermined schedule, say 5 years. However, if the consumer decides to take out the entire contract as a lump sum before the annuity has expired, then penalties based on the redemption schedule in the annuity contract are invoked. If the investor dies, the lump sum annuity is paid to the beneficiary at death, unless other arrangements have been made.

Technically, equity-indexed annuities are characterized as fixed annuities by the various Departments of Insurance in each state. That is, at no time does the investor have any type of variable value such as stocks, bonds or mutual funds within the EIA account. These accounts do not fluctuate in value like a variable annuity would. However, the equity-indexed annuity is also not like your typical fixed annuity.

The Equity-Indexed Annuity Advantage

What sets EIAs apart from a traditional fixed annuity is how interest is credited to the account. Typically, the insurance company will buy an option on a particular index such as the DOW, S&P 500, or NASDAQ. After a period of time, usually one year, the option contract expires. Then one of two things will happen. If the market index has advanced, the option is cashed and interest is credited to the principal of the annuity. Conversely, if the market has pulled back, the option expires and no interest is credited to the account for that year.

In practice, the annuity gains or maintains value each year, but the investment cannot lose value due to negative market fluctuations. (It is also important to note that all EIAs have a minimum guarantee associated with their returns. For example, this guarantee could state that if the market falls each year over the life of the annuity, the insurance company will guarantee payment of 2 % over 88% of the deposited premium.However, it is virtually unheard of for this security feature to be used.) Investors should also be aware that most stock-indexed annuities have a fixed interest account as an additional investment option . When interest rates are high and the stock market is in decline, the fixed account could be used to credit interest on the principal of the annuity.

Stock Index Performance

How do these annuities work? Historically, many of these accounts have averaged returns of 7% or more. In years when the broader markets have performed well, so have EIAs. It is not uncommon for investors to enjoy interest payments during these prosperous years of 10-20% or more. But the crucial value of these accounts is realized during rapid market downturns, when the equity-indexed annuity will maintain its principal as well as interest earnings from prior years.

These facts may explain the recent popularity of EIAs, especially among retirees looking to preserve the hard work of a lifetime. With the market moving up and down so rapidly, many consumers are looking for safety and security without having to sacrifice reasonable interest returns. Of course, these annuities won’t return 50% in a year like a lucky stock or pick fund would, but the peace of mind investors get from knowing their investment can’t go down has many putting up a portion of their funds. retirement in these accounts.