Equity or investment-linked annuities link annuity fund performance to a particular stock or stock index. Typically, the Standard and Poor’s 500 Composite Stock Price Index (S&P 500) is used as an index for such annuities. Investment-linked annuities combine the benefits of annuities with the benefits of investing in growth options. In so doing, they also inherit some of the disadvantages of both financial instruments.
== Pros ==
♦ Reduced market risk
Equity-based annuities bear lower risk than direct investment in growth options, or variable annuities. This is because these annuities involve base guarantees and are more like the mutual fund concept – where the risk is spread. Since a composite index fluctuates less than an individual stock would, an equity-linked annuity would offer participation in the market with reduced risk, although there is still some risk involved.
♦ Higher accumulation rates
One of the primary selling points of the equity indexed annuity is greater market-participation. This often results in higher accumulation rates compared to fixed annuities. In finance, greater risk also involves greater reward. Although equity-based annuities involve more risk than fixed ones, it follows that they have more reward in the form of better accumulation rates.
♦ Tax advantages
Investment-linked annuities that are owned by individuals (not as part of a qualified pension plan) is tax deferred. This means that the investment, contributions and interest are not subject to income tax during the accumulation period. These annuities are subject to annuity taxes on growth (income); hence, the returns are not subject to capital gains during accumulation. However, this means that proceeds are taxed by income tax instead of the lower capital gains tax as well.
♦ Guaranteed lifetime income
As other annuities, one of the main benefits of the investment-linked annuity as a life annuity is the guaranteed lifetime income. This does not apply to all equity-linked annuities, since some of these contacts have shorter terms (five or ten years for example).
== Cons ==
♦ Complexity
Annuities might be relatively intricate financial instruments for the uninitiated. However, the indexed annuities are even more complex. They involve different methods of calculating gains and various indexing methods. Apart from this, a particular equity-based annuity could make provisions for changes in these at different points in the accumulation period. This makes the fine print involved in buying such an annuity far more extensive and complicated.
♦ Fees and charges
Since these annuities involve fund management, they also include investment fees, as are common with variable annuities. Therefore, the potentially higher returns are reduced by management fees on a monthly basis. In addition, these annuities impose higher surrender charges than fixed annuities. The severity of the charges arises from the increased participation in the market and the long-term investments required.
♦ Liquidity risk
This investment risk is one that the equity-linked annuity inherits by being an annuity. Annuity contracts commit your funds for a certain period of time, whether for a lifetime or a stipulated period. While you can break the contract, heavy penalties are incurred for that. This suggests that annuity investors must relinquish access and control of their investment for the period.
♦ Limit on returns and lower guarantees
Some investment-linked annuities impose caps or limits on the returns. Annuity investors might not even benefit from higher rates of return under this method of calculating gains. In addition, the annuity might only guarantee a certain percentage of capital invested, apart from the base accumulation rate. In a worst case scenario, an annuity investor can lose part of the investment upfront and have to play catch-up for a significant period – just to recoup the initial investment value.
In any event, annuity guarantees are only as good as the annuity provider. There are some pitfalls regarding investment-linked annuities that serve to mitigate the benefits. Understanding the terms of the equity-based annuity is vital. The decision to purchase should depend on the annuity, your risk tolerance, and financial circumstances.