A more thorough explanation:

An Equity-Indexed Annuity (EIA) is a financial product offered by insurance companies that provides a minimum guaranteed return along with a return linked to a market index. It has two periods: the accumulation period, where the investor makes a lump sum payment or a series of payments to the insurer, and the payout period, where the insurer makes a lump sum payment or a series of payments to the investor.

However, EIAs have several potential disadvantages, such as surrender charges and tax penalties if the investor cashes out early. The minimum return guarantee may also not kick in until the account has been active for a set period of time. EIAs are complex instruments, and each EIA can vary greatly. Different EIAs use different methods to calculate gains in the index, with each method having distinct advantages and disadvantages.

Investors should pay attention to the following elements of EIAs:

• Participation rates: The higher the participation rate, the greater the impact of an index gain on the value of the annuity.
• Interest rate caps: Specifies a ceiling for the impact of a market index. For example, if the linked market index increases by 10% and an EIA has an interest rate cap of 8%, the investor only benefits up to the cap (8%).
• Administrative fee: This provision can affect the benefits an investor receives by reducing the return from a gain in the linked index by some percentage.

Investors should also investigate the financial strength of the insurance company offering the EIA to ensure they can make their payments. EIAs are not necessarily fraudulent, but they are not suitable for all investors. Investors considering an EIA should be prepared to assess the instrument in detail, conduct research, and ask questions.

For example, an investor may purchase an EIA with a participation rate of 80%, an interest rate cap of 6%, and an administrative fee of 2%. If the linked market index increases by 10%, the investor would only receive a return of 4.8% (80% of the gain minus the 2% administrative fee) due to the interest rate cap and administrative fee.

Another example is an EIA that guarantees a minimum return of 2% per year but only kicks in after the account has been active for five years. If the investor cashes out before the five-year mark, they may incur surrender charges and tax penalties.

Source: