|Investors have snapped up billions of dollars worth of equity indexed annuities over the past few years. These investments provide a guarantee of principal just like a traditional fixed annuity. And the interest rate credited each year is based on the performance of the S&P 500 index. If the market goes up, interest is credited to your account. If the market goes down, your balance will not decline below your original investment.
In comparing equity-indexed annuities, the item to focus on is how each company assigns the interest to your account. Insurance companies use the term "participation" rate to calculate how much of the S&P 500 index change will be credited to your account.
Some companies use the average annual change in the S&P 500 index in calculating your interest. They record the S&P 500 index on the first day of each month. At the end of the year, they total these 12 numbers and divide by 12. This average is compared to the index at the start of the year, and the calculated gain is your interest for the year. However, by testing this averaging system over three decades (a test of historical S&P 500 data), one study found that investors gave up 45% of their returns (past results may not be consistent with future results). In other words, all else being equal, an index annuity which simply measures the change in the S&P 500 index from the original date of your investment to the last day of your term, will provide for much larger interest credits.
So why do investors choose an index annuity with averaging? They either don't understand the above ramifications or they are attracted to another feature. The "annual reset" feature locks in their gain each year. For example, if the investor earns 15% one year, and the market falls the next, that 15% gain is locked in and becomes part of the minimum guaranteed balance by the insurance company.
Index annuities can be very attractive because of the combination of the guarantee provided by the insurance company and the interest that is based on the S&P 500.