Chapter 3-7 Equity Indexed Annuities

Equity-Indexed Annuities are a complex alternative.  More and more people have been purchasing equity-indexed annuities (EIAs) in recent years.  One of the most complex characteristics of an EIA is the approach used to measure the gain in the index to which the annuity is associated.  Due to the differences and complexity of the techniques utilized to credit interest, it will be hard for investors to compare one EIA to another.  Prior to purchasing an EIA, you should comprehend the different characteristics of this investment and be ready to ask your insurance agent, broker, financial planner, or other financial professional if an EIA is suitable for you.

EIAs are intricate financial tools that have features of both fixed and variable annuities.  Their return changes more than a fixed annuity, but not as much as a variable annuity.  This means that EIAs present you with a greater risk than a fixed annuity with the possibility of a higher return, and less risk than a variable annuity with the downside of a lower return.  EIAs provide a minimum guaranteed interest rate combined with an interest rate that is connected to a market index.  Due to the guaranteed interest rate, EIAs have lower market risk than variable annuities.  EIAs also have the possibility of earning returns that are greater than traditional fixed annuities when the stock market is going up.  The guaranteed minimum return for an EIA is generally 90 percent of the premium paid at a 3 percent yearly interest rate.  If you surrender your EIA too soon, you may owe a substantial surrender charge and a 10 percent tax penalty.  The guaranteed return is only as good as the insurance company that provides it, although it is rare that a life insurance company is not able to satisfy its responsibilities, it does happen.  To assist, there are private companies that rate an insurance company’s financial wellbeing.

A market index follows the performance of a particular group of stocks in a specific sector of the market, or in some cases the market as a whole.  There are indexes for nearly all imaginable sectors of the stock market.  The majority of EIAs hinge on the S&P 500, a broad market index, but additional indexes are also utilized.  Several EIAs even let investors choose one or more indexes.

The index related gain is contingent on the specific mixture of indexing characteristics that an EIA utilizes.  To completely comprehend an EIA, be sure you comprehend every characteristic as well, as how the characteristics work collectively, because these characteristics can dramatically affect your investment return.  The first characteristic that is utilized by an EIA is a participation rate.  A participation rate decides how much of the profit in the index will be credited to the annuity.  A second characteristic is the spread/margin/asset fee.  Several EIAs utilize a spread, margin, or asset fee as well as (or instead of) a participation rate.  This percentage will be taken from any profit in the index connected to the annuity.  Interest rate cap is another feature utilized by EIAs.  Several EIAs may put a restriction or upper cap on your return.  This cap rate is typically expressed as a percentage.  This is the maximum rate of interest the annuity will gain.  A number of EIAs permit the insurance company to alter participation rates, cap rates, or spread/asset/margin fees either annually or at the beginning of the subsequent contract term.  If an insurance company decreases the participation rate or cap rate, or raises the spread/asset/margin fees, your return could be unfavorably affected.  Look over your contract thoroughly to see if it permits the insurance company to alter these characteristics.

There are a number of techniques for figuring out the adjustment in the appropriate index throughout the annuity period.  The first indexing technique used is an annual reset.  The annual reset examines the difference in the index from the beginning of the year to the end.  Any drops are ignored.  An advantage of this technique is that your gain is locked in every year.  A disadvantage is that it can be mixed with additional characteristics such as lower cap rates and participation rates, which restrict the interest total you might gain every year.  A second indexing technique is a high water mark, which examines the index value at different times throughout the contract, generally yearly.  It then uses the greatest of these values and examines it in contrast to the index level at the beginning of the term.  An advantage of this technique is that it may credit you with higher interest than additional indexing methods and secure against index declines.  However, a disadvantage is that since interest is not credited until the end of the term, you may not get any index connected profit if you surrender your EIA too soon.  It too may also be mixed with additional characteristics such as lower cap rates and participation rates, which restrict the interest total you might gain every year.  The third technique used by EIAs is point to point, which examines the difference in the index at two separate points in time, like the start and end dates of the contract term.  An advantage of this technique is that it may be mixed with additional techniques, like increased cap and participation rates, that may credit you with more interest.  A disadvantage to this technique is that it depends on an individual point in time to measure interest.  As a result, even if the index that your annuity is connected to is rising during your investment term, if it goes down significantly on the final day of the term, then a portion or all of the previous gain can be erased.  Since interest is not credited until the term ends, you may not get any index connected gain if you surrender your EIA too soon.

Another characteristic that is utilized by an EIA is index averaging.  A number of EIAs average an index’s worth either daily or monthly instead of utilizing the real value of the index on a particularized date.  Averaging may lower the index connected interest total you earn.  Interest calculation is still another characteristic.  The method that an insurance company measures interest accrued throughout the term of an EIA can have a huge disparity in the money you will make.  A number of EIAs pay simple interest throughout the term of the annuity.  Since there is not any compounding of interest, your return will be less.  Another characteristic utilized by EIAs is exclusion of dividends.  The majority of EIAs only include equity index gains from market price adjustments, omitting any profits from dividends.  Because you are not earning dividends, you will not make as much as if you invested directly in the market.

EIAs are long-term investments, withdrawing early may result in taking a loss.  Several EIAs have surrender charges.  The surrender charge can be a percentage of the total taken out, or a lowering in the interest rate credited to the EIA.  Any withdrawals from tax-deferred annuities prior to reaching 59½ years of age are also typically liable to a 10 percent tax penalty as well as to any gain being taxed as regular income.  Because EIAs and other tax-deferred annuities do not offer the same benefits as 401(k)s and other before-tax retirement plans, the majority of investors should only take into consideration EIAs and other annuities after they have made the maximum contribution to their 401(k)s and other before-tax retirement plans.

Losses are a possibility in an EIA.  Most insurance companies only ensure that you will receive 90 percent of the premiums you paid, plus at minimum 3 percent interest.  As a result, if you do not earn any index connected interest, you can lose money on your investment.  One situation in which you would not get any index connected interest is if the index connected to your annuity declines in value.  The other method in which you may not get any index connected interest is if you surrender your EIA before it reaches maturity.  A number of insurance companies will not credit you with index connected interest when you surrender your annuity too soon.

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