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Equity Indexed Annuities

Last update on: Dec 27 2018
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Equity indexed annuities are back. Sharp stock market moves seem to stir sales of these annuities. A strong stock market draws conservative investors to them, seeking higher returns than their fixed income investments. A bear market causes other investors to look for a safer way to invest in stocks. Unfortunately, few investors really know what they are buying and what their potential returns are with equity indexed annuities.

An equity indexed annuity starts with two simple, attractive notions. The returns of the annuity are tied by a formula to a stock market index instead of to interest rates. In addition, unlike the stock market the EIAs offer bear market protection. Most EIAs guarantee that the account will not decline in value. You might find a few with a modest minimum return of 1% or so, but most have a minimum return of 0%.

The EIA essentially is a hybrid of variable annuities and fixed annuities. Like the variable annuity, returns can be higher than current interest rates when the stock market does well. Like the fixed annuity, returns won’t be negative when the stock indexes decline. As with all annuities, the EIA’s earnings are tax deferred until distributed.

Each insurer has its own version of the EIA, and the differences in terms can make it difficult to compare the annuities. Let’s review the different features to examine.

Index. You do not get to choose stock investments in an EIA. Instead, the contract names a market index that will be the benchmark for computing returns. Most EIAs peg their returns to the S&P 500. You might find an annuity with a different index, but this is by far the most common benchmark.

Valuation formula. Here is the real key to your returns and the source of confusion for many investors. EIAs do not always measure performance than way most expect.

Most investors compute returns by comparing an index’s value a year ago to the value today. The percentage difference is the return for the 12 months. This is known as point-to-point valuation, and more EIAs are adopting it.

But it is common for an EIA to use a different formula. The EIA might total the monthly or daily returns of the index, average the total, and use that as the percentage return for the year. Because stock market returns tend to be bunched in brief bursts, the averaging methods usually result in lower returns than the point-to-point method.

Participation rates. Some EIAs credit the policy owner with the full stock return or the year as determined by the valuation formula; others have a ceiling that limits the participation. For example, the EIA might limit the credited return to 75% of the return computed under the valuation formula.

Return ceiling. An additional way of limiting the return in EIAs is an explicit limit on the potential return each year. Ceilings generally are 7% to 10%. For example, an EIA might say that the account earns 75% of the return under the valuation, but up to a maximum return of 8% each year.

Tradeoffs. The valuation formula, participation rate, and return ceiling need to be considered together. Generally, the insurers make trade offs between the three. EIAs with less than 100% participation and with restrictive valuation formulas tend to have higher return ceilings of 10% or so. Typically an EIA that allows 100% participation will have an annual ceiling of 7% to 8%. If an insurer or broker is focusing on one of the features, be sure to study the others.

The trade off requires some consideration. The combination that intuitively seems the most attractive often isn’t.

The long-term returns of stock indexes average 8% to 10%. But the year-to-year returns tend to stray far from the average. Many years in which returns are positive (and the returns are positive about two thirds of years) tend to have greater than 10% returns. There are few years in which stock index returns are close to the long-term average. Let’s take a look at how this history might affect your choice.

Suppose the index returns 10% one year. One EIA has 100% participation but a 7% cap. That EIA’s investors get credited with a 7% return. Another EIA has 75% participation but a 10% cap. Those investors get 7.5% credited to their accounts for the year.

Under past return patterns, an investor is likely to earn a higher return with a higher cap and a lower participation rate. That’s because an index’s returns each year tend to be far from the averages. Good years in the market tend to be very good years. If this pattern of returns continues in the future, the lower participation rate-higher cap EIA is likely to be the better choice.

Some EIAs have multi-year caps. For example, a policy might say that the return over two years will not exceed 15%, regardless of any other policy provisions. That means no matter what the indexes do, the policy will not get greater than a 7.5% annual return over any two-year period.

Fees. As with other annuities, there is a wide range of fee structures for EIAs. Many EIAs are no-load. The trick is the annual fees.

Most EIAs now charge fees only when returns are positive. But the more generous the EIA’s policy of crediting returns is, the higher the fees tend to be. An EIA with 100% participation and a high or no ceiling likely will have annual fees of 2% or more. That could be great if the index returns 20%. But when the market returns 10% or less, you would get a better net return from what seems to be a more restrictive EIA.

Again, it pays to look at the interplay of fees, ceilings, valuation formulas, and participation rates under different return patterns. A period of steady, low returns would favor an EIA with low fees. A pattern of widely varying returns with the positive returns above 10% would be rewarded by 100% participation and no ceiling with higher fees.

Many EIAs allow fees and charges to be changed, and the maximum fees that can be imposed are quite high. Be sure to ask what is being charged to current policy holders.

Also be sure to check on surrender charges and minimum holding periods. The EIAs with the most attractive initial terms tend to be those with the highest penalties for withdrawing from the EIA.

Changes. Most EIAs retain the right to change any of these provisions. There might be a limit to the potential amendments, but the insurer can review the terms each year. A 100% participation rate can become 75%, or a 10% cap could decline to 8%. There’s not much the policy holder can do except realize that terms that are more attractive than those on other EIAs can change at any time.

Commissions. Most EIAs offer the selling agent or broker generous commissions of 5% to 9%. The higher commissions usually are on policies with high surrender charges or more restrictive terms. The commissions usually paid directly by the insurance company.

Not securities. Unlike variable annuities, an EIA is not considered a security. You are not making a stock market investment, so the agent does not need a securities license. An insurance license will do. It also means that only insurance regulations, not securities laws, cover the sale, disclosure, and other aspects of the transaction.

Investment bonuses. Some EIAs offer bonuses. For example, an EIA might credit an extra 10% to the policy holder’s account for purchasing the annuity. Or 1% annually might be credited for each year the policy is owned. Such bonuses almost always come with higher surrender charges, longer required holding periods, and other restrictions. Be sure you know the trade offs.

An EIA is neither a stock market investment nor a traditional fixed annuity. It can be an appropriate investment for someone who is too conservative for the stock market but recognizes the need to try to earn higher returns than are available from interest-based vehicles such as fixed annuities, bonds, and certificates of deposit.

The returns of an EIA will vary considerably from year to year. The good news is that, unlike a stock market investment, the return will not be less than zero. On the other hand, an investor won’t know until after the year what, if anything, the return for the year is. In addition, in years of strong stock market returns, the investor might get credited with a fraction of those returns.

A potential EIA investor needs to review different EIAs, study all the terms in the policies, and understand the trade offs. Different EIAs will appeal to different types of investors, and many investors will find all EIAs to be inappropriate for them.

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