Equity-indexed annuities: Indexing methods explained
The equity-indexed annuity (EIA) was introduced in 1995 and became a fast-growing alternative to fixed-rate annuities and certificates of deposits.
EIAs provide a guaranteed interest rate combined with the ability to earn a percentage of certain market-driven indexes, borrowing characteristics from fixed-rate and variable-rate annuities.
The percentage of the index's gain that a customer receives is called the "participation rate."
There are many ways insurance companies calculate your index-linked returns. Here are the most common:
- The point-to-point method compares the values of the index at two distinct points, such as the end and beginning of the contract term, ignoring all the fluctuations in between. This can protect you against declines in the middle of the term, but it can be a drawback if the index increases throughout most of the term and then drops dramatically the last day.
- The high-water-mark method notes the index level at various points during the term, usually the policy anniversary dates, and then compares the highest level to the start date to calculate earnings.
- The low-water-mark method examines the index at certain points during the term, such as policy anniversary dates, and compares the index at the end of the term to the lowest overall index value. Interest is credited based on the difference between the index value at the beginning of the term and the lowest index value. Both the high-water and low-water methods tend to lessen the risk of market declines.
- The annual reset, or ratchet, method compares the index at the beginning of the contract year with the end of the contract year. Any resulting decreases are ignored, and your gain is locked in each year.