Equity-indexed annuity

Caveat: Equity Indexed Annuities are strongly not recommended for investors. Please ask in the forum for advice.

An Equity Indexed Annuity (EIA), also known as a Fixed Indexed Annuity (FIA), or Indexed Annuity is a fixed annuity whose interest is based, in part, on the performance of a securities index (equity, commodity, or bond). The most common index used in most contracts is the S&P 500 index of common stocks. FIA's were introduced in the mid-1990's and have exhibited steady growth in the marketplace. Fixed indexed annuities are complex instruments with combinations of features which affect the crediting of interest.

Reasons for caution
There is a concensus by those outside the insurance industry that these products do not have the client's interest as a primary focus. Equity Indexed Annuities are insurance contracts, not investment vehicles. The overview below attests to the underlying level of complexity inherent in these products, which eludes many investors.

Aggressive sellers of these annuities have been cited by critics for abusive sales practices. As of July 2010, the SEC and state insurance departments were contesting which regulator should have regulatory control over this product.

The FINRA (Financial Industry Regulatory Authority) has issued an alert on these products, which is listed below.

A study by the Securities Litigation & Consulting Group (SLCG) concluded the following:
 * Existing equity-indexed annuities are too complex for the industry’s sales force and its target investors to understand the investment.
 * This complexity is designed into what is actually a quite simple investment product to allow the true cost of the product to be completely hidden.
 * The high hidden costs in equity-indexed annuities are sufficient to pay extraordinary commissions to a sales force that is not disciplined by sales practice abuse deterrents found in the market for regulated securities.
 * Unsophisticated investors will continue to be victimized by issuers of equity-indexed annuities until truthful disclosure and the absence of sales practice abuses is assured.

Investors are encouraged to consider alternatives. One study showed that a 30% S&P 500 / 70% U.S. Treasury bond portfolio had better performance than an Equity Indexed Annuity. Other examples are described in the Baron's article below.

How they work
An indexed annuity is a contract issued by a life insurance company that generally provides for accumulation of the purchaser's payments, followed by payment of the accumulated value to the purchaser either as a lump sum, upon death or withdrawal, or as a series of payments (an "annuity"). During the accumulation period, the insurer credits the purchaser with a return that is based on changes in a securities index, such as the Dow Jones Industrial Average, Lehman Brothers Aggregate U.S. Index, Nasdaq 100 Index, or Standard & Poor's 500 Composite Stock Price Index.

The insurer offers a minimum guaranteed interest rate combined with an interest rate linked to a market index. The specific features of indexed annuities vary from product to product.

Index-linked interest
Indexed annuities credit interest using a formula based on changes in the index to which the annuity is linked. The formula decides how the additional interest, if any, is calculated and credited. How much additional interest you get and when you get it depends on the features of your particular annuity.

It is essential to understand not only the individual features, but how they work together. Below is a brief summary of the more common contract features, each with advantages and disadvantages not described here. Consult both the FINRA's Investor Alert and the NAIC Buyer's Guide To Equity-Indexed Annuities for the full details.


 * Indexing Method: There are several methods for determining the change in the relevant index over the period of the annuity. These varying methods impact the calculation of the amount of interest to be credited to the contract based on a change in the index.
 * Annual reset (ratcheting): Compares the change in the index from the beginning to the end of each year.
 * High-water mark: Looks at the index value at various points during the contract, usually annual anniversaries. It then takes the highest of these values and compares it to the index level at the start of the term.
 * Point-to-point: Compares the change in the index at two discrete points in time, such as the beginning and ending dates of the contract term.
 * Term: The index term is the period over which index-linked interest is calculated.
 * Participation Rate: The participation rate decides how much of the increase in the index will be used to calculate index-linked interest. For example, if the calculated change in the index is 9% and the participation rate is 80%, the index-linked interest rate for your annuity will be 7.2% = (9% x 80%).
 * Spread/Margin/Asset Fee: The index-linked interest rate may use a spread, margin or asset fee in addition to, or instead of, a participation rate. This percentage will be subtracted from any gain in the index linked to the annuity. For example, if the index gained 9 percent and the spread/margin/asset fee is 3.4 percent, then the gain in the annuity would be only 5.6 percent.
 * Interest Rate Cap: There may be a "cap" or upper limit on your return. Generally stated as a percentage, this is the maximum rate of interest the annuity will earn. For example, if the index linked to the annuity gained 12 percent and the cap rate was 8 percent, then the gain in the annuity would be 8 percent.
 * Index Averaging: An index may be averaged, rather than use the actual value on a specified date, which may reduce the amount of index-linked interest you earn.
 * Interest Calculation Method: Interest may be calculated as simple interest, thus losing the effects of compounding which results in a lower return.
 * Exclusion of Dividends: Most equity indexed annuities only count equity index gains from market price changes, excluding any gains from dividends, i.e. indexes track stock prices excluding dividends. Since you're not earning dividends, you won't earn as much as if you invested directly in the market. Note that this will be less than the return on an investment in a mutual fund tracking that index.

Surrender Charges
Surrender charges are commonly deducted from withdrawals taken by a purchaser. The maximum surrender charges, which may be as high as 15-20%, are imposed on surrenders made during the early years of the contract and decline gradually to 0% at the end of a specified surrender charge period, which may be in excess of 15 years.

Imposition of a surrender charge may have the effect of reducing or eliminating any index-based return credited to the purchaser up to the time of a withdrawal. In addition, a surrender charge may result in a loss of principal, so that a purchaser who surrenders prior to the end of the surrender charge period may receive less than the original purchase payments. Many indexed annuities permit purchasers to withdraw a portion of contract value each year, typically 10%, without payment of surrender charges.

Guaranteed Minimum Value
Indexed annuities generally provide a guaranteed minimum value, which serves as a floor on the amount paid upon withdrawal, as a death benefit, or in determining the amount of annuity payments. The guaranteed minimum value is typically a percentage of purchase payments, accumulated at a specified interest rate, and may not be lower than a floor established by applicable state insurance law. In the years immediately following their introduction, indexed annuities typically guaranteed 90% of purchase payments accumulated at 3% annual interest.

More recently, however, following changes in state insurance laws, indexed annuities typically provide that the guaranteed minimum value is equal to at least 87.5% of purchase payments, accumulated at annual interest rate of between 1% and 3%. Assuming a guarantee of 87.5% of purchase payments, accumulated at 1% interest compounded annually, it would take approximately 13 years for a purchaser's guaranteed minimum value to be 100% of purchase payments.

Possibility of loss
As stated above, many insurance companies only guarantee that you'll receive 87.5 percent of the premiums you paid, plus 1 to 3 percent interest. Therefore, if you don't receive any index-linked interest, you could lose money on your investment. One way that you could not receive any index-linked interest is if the index linked to your annuity declines. The other way you may not receive any index-linked interest is if you surrender your EIA before maturity. Some insurance companies will not credit you with index-linked interest when you surrender your annuity early.

Forum discussions

 * Equity Indexed Annuities

Articles

 * Designed to Deceive, from Barrons.com
 * A Forbes.com tutorial series by forum member Mel Lindauer:
 * Annuities: Good, Bad Or Ugly?
 * How To Cut The Cost Of A Variable Annuity
 * For Some Retirees, This Annuity Makes Sense
 * The Truth About Equity-Indexed Annuities
 * Variable Annuities Don't Belong In Retirement Plans
 * Fixed Deferred Annuities: CDs With Gotchas

Papers

 * Gaillardetz, Patrice, and X Sheldon Lin, “Valuation of equity-linked insurance and annuity products with binomial models.”, North American Actuarial Journal 10:4 (October, 2006)
 * Reichenstein, William, "Financial Analysis of Equity-Indexed Annuities" (Digest Summary), CFA Institute, Winter, 2009, (abstract and summary only)