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Understanding Equity-Indexed Annuities and Their Risks

Sales of equity-indexed annuities (EIAs) have grown recently. A confusing aspect of EIAs is the method to calculate the gain in the index linked to the annuity. The variety of methods used to credit interest make it difficult to compare EIAs.

Annuities come in two types: fixed and variable. With a fixed annuity, the insurance company guarantees both the rate of return and the payout. A variable annuity’s rate of return is not stable, but varies with the performance of the stock, bond, and money market investment options that you choose.

EIAs are complex financial instruments that have characteristics of both fixed and variable annuities. Their return varies more than a fixed annuity, but not as much as a variable annuity. As such, EIAs pose more risk (but have more potential return) than a fixed annuity, but less risk (and less potential return) than a variable annuity.

EIAs offer a minimum guaranteed interest rate combined with an interest rate linked to a market index. Because of the guaranteed interest rate, EIAs have less market risk than variable annuities. EIAs also have the potential to earn better returns than traditional fixed annuities when the stock market is rising.

There are several methods for determining the change in the relevant index over the period of the annuity. These varying methods impact the calculation of the amount of interest to be credited to the contract based on a change in the index.

Beware that EIAs are long-term investments and withdrawing funds early may mean taking a loss. Many EIAs have surrender charges. The surrender charge can be a percentage of the amount withdrawn or a reduction in the interest rate credited to the EIA. Further, any withdrawals from tax-deferred annuities before you reach the age of 59½ are generally subject to a 10% tax penalty in addition to any gain being taxed as ordinary income.

Be careful that you also can lose principal in EIAs. Many insurance companies only guarantee that you’ll receive 90% of the premiums you paid, plus at least 3% interest. Therefore, if you don’t receive any index-linked interest, you could lose money on your investment.