Fixed annuities guarantee your income based on current interest rates. Facing a long retirement horizon, you may want to consider relying a little on the markets to enhance your annuity income. An equity-index annuity offers that chance, but you must understand how it works.

Equity-index annuities combine features of traditional insurance products (guaranteed minimum return) and traditional securities (where the return is linked to equity markets). Depending on the mix of features, an equity-index annuity may or may not be a security. In fact, the typical equity-index annuity is not registered with the SEC (but may be in the near future and become classified as a security).

Here’s how they work:

During the accumulation period – when you make either a lump sum payment or a series of payments – your insurance company credits you with a return based on changes in an equity index. The S&P 500 is a typical index although some equity index annuities may be based on indexes such as EAFE, he NASDAQ 100 or the Wilshire 5000.

The insurance company typically guarantees a minimum return of 90% of the premium plus a minimum interest rate. With an equity index annuity, surrender charges can last for several years, and it is possible to lose money if the investor cancels the policy in the early years or does not earn index-linked interest. If there is no increase in the underlying index during the designated term, investors receive only the minimum guaranteed rate minus expenses and withdrawals prior to age 59½ are subject to 10% penalty.

After the accumulation period, the insurance company will make periodic payments to you unless you take your contract value as a lump sum.

Understanding how the interest rate used in your contract is linked to the equity index determines what advantage you really get over a fixed annuity. Consider these procedures in the linking process:

**Participation Rates**: The participation rate determines how much of the index’s increase will be used to compute the index-linked interest rate. For example, if the participation rate is 75% and the index increases 10%, the return credited to your annuity would be 7.5% (10% x 75% = 7.5%).

**Interest Rate Caps**: Some equity-indexed annuities set a maximum rate of interest that the equity-indexed annuity can earn. If a contract has an upper limit, or cap, of 7% and the index linked to the annuity gained 7.5%, only 7% would be credited to the annuity.

**The Margin**, Spread, or Administrative Fee: The index-linked interest for some annuities is determined by subtracting a ‘fee’ percentage from any gain in the index. This fee is sometimes called the “margin,” “spread,” or “administrative fee.” An annuity with a “spread” of 3%, will credit a return of only 7% if the index gained 10% (i.e. 7% = 10% – 3%).

The method of indexing the index change will affect your return too. A couple of indexing methods are:

**Annual Reset** (or Ratchet). This method credits index-linked interest based on any increase in index value from the beginning to the end of the year.

**Point-to-Point**. This method credits index-linked interest based on any increase in index value from the beginning to the end of the contract’s term.

Know the features of any equity index annuities you consider to see their impact on your annuity’s potential return. Use the fixed annuity calculator to get an estimate of your future value at different interest rates.