Comparing Equity Index Annuities to ETFs

Equity index annuities (EIA) earn interest based on the performance of another financial instrument. Usually this is a stock or an equity index. The most commonly used index for an EIA is the S&P 500.

An alternative to investing in an equity index annuity is an exchange-traded fund (ETF). ETFs, like EIAs, are securities that track indexes. Or, at least most ETFs are. They can also be set up to track commodities and sectors. ETFs offer the same diversification benefits of equity index annuities and mutual funds, but have the flexibility and transparency of a stock.

With an equity index annuity, interest is credited to the annuity based on a formula that is linked to the performance of the equity index. The interest rate of the policy will not necessarily match the performance of the index exactly. The performance of an EIA is based on the indexing method and the participation rate that is used. In addition, an EIA will pay investors a minimum interest rate in case the index performance for the accumulation period is not above a certain threshold.

ETF pricing is more straightforward and transparent. ETF prices fluctuate throughout the day based on the demand and supply metrics of the open market. As a result, any trade that can be performed with stocks can be done with an ETF. For example, investors have the capability for options trading and there is no minimum investment requirement for ETFs.

With this flexibility, comes risk. ETFs have similar risk levels to that associated with trading stocks. One of the advantages of equity index annuities over ETFs is that they are low risk. They also offer good growth based on the market. In addition, the investor does not have to manage their premiums or continually manage their investments. Once the contract is initiated, it is linked to the performance of the index for the term of the contract. Moreover, unlike ETFs, index annuities cannot lose capital - a significant advantage during down markets.

EFTs are traded on a secondary market by individuals. ETFs generally have lower fees associated with them then other investment vehicles because they are not actively managed. This does however mean that the investor needs to manage his portfolio more closely

Another area to consider is tax treatment differences between equity index annuities and ETFs. Equity index annuities have tax-deferred benefits. Income is not taxed until it is withdrawn. In addition, transfers between sub-accounts are tax-free. One downside to equity index annuities, however, is that there is a 10% tax penalty if income is withdrawn by the investor before they are 59.5. Annuities are, after all, retirement savings instruments, which is yet another key point of distinction between the two investment types.

An advantage of EFTs is that their earnings qualify as capital gains, as opposed to the ordinary income tax status of annuities. Additionally, because there is no tax penalty for withdrawals at any age, ETFs appeal to younger investors or those whose goals are short-term based.

ETFs can actually be used to meet short, intermediate, or long-term goals of investors. Equity index annuities are well-suited for investors who have a time horizon of five or more years.