Reader inquiries about equity-indexed annuities (EIAs) are rising. It’s not surprising. Investor interest in EIAs surges during difficult markets, and data show money is pouring into these annuities. As with most insurance products, the question is whether investors are buying these annuities or being sold them by strong presentations.
Events are lined up in favor of EIAs. Markets for stocks and other risky assets are volatile and generating poor returns. Investors are on edge. Interest rates on safe investments are too low to meet return goals. Financial advisors are quick to offer EIAs to investors dissatisfied with traditional investments.
EIAs guarantee safety of principal and often a minimum return with the potential for a higher return when a stock market index does well. That’s an enticing combination after the markets of the last 10 years.
Yet, be sure an EIA is the right investment for you and that you’re buying the investment you think you are. It’s not unusual for EIA investors to be unpleasantly surprised at the returns credited to their accounts.
You’re not investing in specific assets such as stocks and bonds. You’re receiving a promise from the insurance company to be paid based on the returns of a specific stock index or some other measure. You have only a promise from the insurer backing the contract. (Versions of EIAs also are offered by banks as certificates of deposit and by brokers, but they tend to be backed and managed by insurance companies. The bank versions usually have the principal insured by the FDIC.)
There’s usually a guaranteed annualized return of 1% to 3%. But the return might be guaranteed over the life of the policy, not each year. Suppose the policy has been in force for a few years and has earned a 4% annualized return. The stock index has a negative return for the current year. You may receive a 0% return this year, because the prior years’ cumulative return exceeds the guaranteed minimum. You have to check the terms of the minimum return and understand exactly what is guaranteed. EIAs that have the highest potential returns usually offer no guaranteed minimum return but guarantee only a return of your initial investment.
The unique feature of an EIA is it could credit a higher return to your account when the stock market index rises. The trick is understanding how your stock-based rate of return is calculated. You usually won’t earn the index’s published return. When stocks are up 10% for the year, you can’t assume 10% will be credited to your account.
You don’t need to know all the details of how the return is calculated, but you should know how these key terms are defined in the policy.
Index. Different stock indexes have different rates of return and levels of volatility. Know the index a policy uses, and also when the insurer is able to change it.
Participation rate. When the insurer credits your account with the same return as the index, that’s 100% participation. Most credit your account with a participation rate of 50% to 75%.
Return ceiling. In a strong bull rally you aren’t going to receive the index’s full return, even if you have 100% participation. Most EIAs have an additional limit called the return ceiling. That’s the maximum return you’ll receive for a year regardless of how much stocks return. Ceilings generally are 7% to 10%. 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.
Return Formulas
The return formula is the real trick to these policies. Analysts estimate there are over 30 formulas in use to credit income to EIA accounts. Suppose you’re looking at a policy with a 75% participation rate and an 8% annual ceiling. You would think when the index has a 10% total return for the year, your account will be credited with a 7.5% return (75% of 10% and below 8%). That’s not likely to be the case.
Most of the formulas aren’t that simple. There are two basic types of formulas (with many variations in the details) and a host of clauses and qualifications to the computations. Here are the two basic formulas and key ways they could be modified.
Point-to-Point. This is the method most people assume is used. The difference between the beginning and ending values of the index over the period are used to credit the account. Point-to-Point likely will give a higher return in a bull market than the other methods, but it exposes the owner to more risk in a declining market and to higher volatility than the other methods. It also is likely to be accompanied by lower ceilings, participation rates, and limits than the other methods.
Averaging. The ending values of the index for each period (usually months or days) within the longer averaging period (usually a year) are added. This total is divided by the number of periods. The difference between the index’s beginning value and the average value is the return for the year. Averaging methods results in very different returns than Point-to-Point, because positive stock market moves tend to be bunched within short time periods, and the rest of the time the index is flat or declining.
Insurance analysts estimate that in a bull market an averaging method credits the account with about half of the index’s total return, which is why it tends to be used on EIAs with higher ceilings and participation rates.
The method does have advantages. It reduces the damage from funding an account shortly 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 gives you some credit for the earlier gains.
Annual Reset. The annual reset method starts with either Point-to-Point or an averaging method. But it prevents bad years from taking away gains. The gains from one year establish a new account floor. Future losses cannot bring the account value below that level.
Suppose Max Profits put $100,000 into an EIA. After eight years, the account value is $150,000. The ninth year the index declines 10%. The account value still is $150,000 at the end of the ninth year.
The annuity owner might be able to select the reset period. An annual reset method can be good in trading range markets but likely will be accompanied by lower annual caps on returns and lower participation rates.
High Water Look Back. This method also starts with either Point-to-Point or an averaging method. Traditionally it was infrequently offered but it becoming more common in EIAs and other insurance products. It provides that the account value credited at the end of the contract will be the highest of the values on the contract anniversary dates. For example, an EIA is owned for 10 years. The index rose steadily during the first nine years, giving a rising account value. The index tumbles the tenth year. When the contract is terminated, the account is credited with the value on the second-to-last anniversary date instead of the lower value on the last anniversary date. Note that the credited value is not the highest value during the 10 years but the highest on the anniversary dates, which is the date the EIA was initiated.
More Terms to Consider
There are at least two other key points in the formula to consider. Under some policies, stock dividends are not reinvested. Only changes in the index value are used. The total return figure you see published in performance reports won’t be the number used in the calculations.
Also, when the credited rate of return is applied to the account after the first year, the insurer might use simple interest instead of compound interest.
When comparing EIAs, you need to be aware of the trade offs in all these factors. Generally, insurers make trade offs between the return formula, participation rate, and return ceiling. 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 return ceiling of 7% to 8%. If an insurer or broker is focusing your attention on one of the features, be sure to study the other factors.
The combination that intuitively seems the most attractive often isn’t. Suppose two EIAs use the same stock market index as the benchmark, and it returns 10% one year. One EIA has 100% participation rate but a 7% cap. That EIA’s investors get credited with a 7% return. Another EIA has 75% participation rate but a 10% cap. Those investors get 7.5% credited to their accounts for the year.
Based on past market return patterns, an investor is likely to earn a higher return over time with a higher annual 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 well above average. If this pattern of returns continues in the future, the lower participation rate/higher cap EIA is likely to be the better choice.
Expenses. After the return for the year is calculated, fees are subtracted and the net-of-fees return is credited to the account. Most EIAs 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, an EIA with a less generous crediting policy and lower fees would generate a higher net return.
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% could be a good time to own an EIA with 100% participation, no ceiling, and higher fees.
Also check 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 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%. Expenses also can be increased. You can ask the insurer how these features were changed for existing EIA holders.
Commissions. Most EIAs offer the selling agent or broker generous commissions of 5% to 9%. Higher commissions usually mean a policy has high surrender charges or more restrictive terms.
Investment bonuses. Some EIAs offer bonus interest credits to new accounts. For example, an EIA might credit an extra 10% after the first year to the policy holder’s account. 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 or fees. Interest rate bonuses also sometimes are offered by weaker insurers that need to bring in new investments. Keep in mind they aren’t free.
Distribution phase. An EIA imposes a surrender charge if the investor withdraws all or some of the money before a minimum period (usually at least seven years) has passed. The longer the lock up period, the more generous other terms tend to be.
Also, even after the lock up period has passed, some annuities do not allow the investor to withdraw money at will. They might require annuitization – a stream of fixed payments from the insurer. Bonus interest may also require annuitization. Others allow only a maximum amount of 10% or so to be withdrawn in any one year. Don’t be dazzled by generous front-end terms that are taken away by limits on how and when money can be withdrawn.
Insurer safety. The main guarantee behind the annuity is the promise of the insurer to make the payments. Deal only with one or more insurers that have been around a long time and are in strong financial condition.
An EIA is neither a stock market investment nor a traditional fixed annuity. It can be appropriate for someone who doesn’t want stock market risk but needs or wants higher returns than are available from interest-based vehicles. The returns of an EIA will vary considerably from year to year. The good news is that, unlike a stock market investment, the return any year 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 years of strong stock market returns, the investor likely will be credited with a fraction of those returns.
A potential EIA investor needs to review different EIAs, study the contract terms, and understand the trade offs. Different EIAs appeal to different types of investors, and many investors will find all EIAs to be inappropriate for them.
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