What are Index Annuities?
An index annuity, also known as an equity-indexed annuity (EIA), is a contract with an insurance company to receive periodic payments in the future, in exchange for payments or premiums paid up-front. What differentiates index annuities from other types of annuities is the link to a securities market index, such as the S&P 500. If the linked index goes up, the interest rate of the annuity goes up. If the index goes down, so does the interest rate earned by the annuity. Most index annuities have provisions which limit how much the rate can decrease, often guaranteeing a certain minimum return.
The participation rate of an index annuity is a measure of how much impact changes in the index have on the value of the annuity (in other words, how closely that annuity is tied to the market). This may also be expressed as a spread, the difference between the increase in the index and the increase in the annuity’s interest rate.
Index annuities have become increasingly popular, with sales exceeding $23 billion in 2004. Like other annuities, index annuities pay high commissions on sales, creating an incentive for brokers to engage in highly-aggressive sales tactics.
Problems with Index Annuities
Index annuities are not inherently fraudulent, and may be suitable for some investors. Problems arise when they are sold to investors without regard to whether the investment is suitable for the investor. Index annuities, like other annuities, generally carry stiff penalties (“surrender fees”) for early withdrawal of funds, making them unsuitable investments for investors who know they will need to withdraw money within a short time horizon.
Other problems arise with how index annuities are marketed and sold. They are sometimes touted as “investments without risk,” or a way to invest in the stock market without the risk of losing money. These claims are false, particularly for investors who need to withdraw money before the maturity date. Another problem involves who sells index annuities. The vast majority of index annuities are sold not by stockbrokers or financial advisers, but insurance agents, who are not bound by the same regulations imposed on sellers of securities.