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How to Maximize Returns in Equity Annuities

Last update on: Dec 27 2018
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Investment dollars are pouring into equity index annuities. These annuities come close to producing what retirees and near-retirees want and need: guaranteed income with safety of principal and inflation protection.

We covered EIAs in past visits. They are a hybrid of fixed annuities and variable annuities. An investor pays a premium to the insurer to establish an annuity account. The insurer selects a stock market index, and credits the account with interest based on the index’s returns.

Most EIAs guarantee a minimum investment return, so the account will not lose money even when the stock index declines. There usually is a maximum return, as well. The investor has the potential to get higher returns than from a fixed annuity if the stock index appreciates over time. But the investor will not participate in the full gains of the index and also will not suffer in full from any declines in the stock index.

There are several key provisions of an EIA to examine before investing in one. These include fees, the stock index used, commissions, the insurer’s ability to change terms, participation rates, and limits on annual returns. See the September 2004 issue or the Annuity Watch section of the Archive on the members’ section of the web site for details.

Perhaps the most important provision is the way in which the returns credited to the account are calculated. Most people after hearing the basics about EIAs think that if the stock market appreciates 20%, their accounts will increase by 20%. EIAs are not that simple. In this visit, we will focus on understanding the different ways returns might be computed.

Insurance experts estimate that there are in use more than 30 different methods of calculating annual returns. These can be classified into four broad categories. Understand these options, and you will be able to compare different EIAs.

Averaging. Under this simple method, the ending values of the index for each period are added. The total is divided by the number of periods. The difference between the index’s beginning value and the average value for the year is the return for the year. The method usually uses either months or days for the measuring periods.

Most of the time stock indexes tend to be flat or declining. Gains usually are concentrated in relatively brief periods. As a result, when the index’s return for the year is positive, this method tends to credit the account with less than the index’s total return for the year. Insurance analysts estimate that in a bull market, this method credits the account with about half of the index’s actual gains.

The averaging method tends to be offered with higher annual caps and participation rates. It also reduces the damage from funding your account a few days before a major market drop. Also, if the index rose for much of the year but suffered a major decline near the end, the averaging method will give you credit for those early gains.

High Water Look Back. This method is infrequently offered. It provides that the account value you are credited with at the end of your contract will be the highest of the values on your contract anniversary dates.

For example, suppose you own an EIA for 10 years. The index rose steadily during the first nine years, giving you a rising account value. But the index tumbles the last year. When you terminate the contract, you will be credited with the value on your second-to-last anniversary date instead of the lower value on your last anniversary date. Note that you will not get the highest value you might have had during the 10 years. Only the anniversary dates are examined.

Point to Point. This is the method most people use to calculate returns and initially assume is used on EIAs. The beginning and ending values of the index over the contract period determine the index return that is used to credit your account.

Point to Point likely will give you a higher return in a bull market than the other methods. Of course, it exposes you to more risk in a declining market and higher volatility than the other methods. It also is likely to be accompanied by lower caps, participation rates, and other limits than some of the other methods.

Annual Reset. The annual reset method prevents bear market years from taking away most of your bull market gains. The index returns from your ownership period are not averaged. Instead, the gains from one year establish a new account floor. Future losses cannot bring the account value below that level.

Suppose you put $100,000 into an EIA. After five years, the account value is $150,000. The sixth year the index declines 10%. Your account value still is $150,000 at the end of the sixth year.

An annual reset method can be good in the trading range markets we have experienced the last five years and that I anticipate for the coming years. Keep in mind that a generous method such as the Annual Reset likely will be accompanied by lower annual caps on returns and lower participation rates.

The best method for you depends on your goals, risk tolerance, and your outlook for the markets. You can learn more details about EIAs by asking for the free booklet The Future of Retirement Savings by David T. Phillips and Todd Phillips (WealthMasters, Inc., 3200 N. Dobson Road, Bldg. C, Chandler, AZ 85224; 800-223-9610).

The discussion here has used simplified examples. While the basic methods are the same, an EIA will couple a method with different caps, participation rates, and other features and might even combine elements of more than one method.

In an EIA, you are not investing in stocks and cannot choose your account’s investments. Your account will be credited with interest each year. The amount of that interest will depend on how a selected stock index performs and, of course, on the crediting formula used by the insurer.

Also, an EIA is not a liquid investment like the stock market. There likely will be a surrender penalty if you want the money returned before a minimum number of years passes.

Good candidates for EIAs are conservative investors who want the potential for higher returns than bonds but do not want all the risk of stocks. By careful selection of the index used, crediting methods, participation rates, caps, and other terms, you can select an EIA that has the right relationship between risk and potential return for you.

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