Equity-indexed annuity

From Bogleheads
Jump to: navigation, search

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. Indexed annuities were introduced in the mid-1990's and have exhibited steady growth in the marketplace. Indexed annuities are complex instruments with combinations of features which affect the crediting of interest.


EIA/FIAs are insurance contracts, not investment vehicles. The overview below attests to the underlying level of complexity inherent in these products, which eludes many investors.

Indexed insurance products, like most insurance retirement products, are designed for persons in a position to hold the products for a number of years. Accordingly, they may not be suitable for persons, regardless of age, who could not be expected to keep their products for the long term, or are looking for a product that will produce a stream of income in the near future. This is because surrender in the short term could be subject to surrender charges and tax consequences that could decrease the dollar value of benefits otherwise available.[1]

Regulatory and industry concerns

Aggressive sellers of these annuities have been cited by critics for abusive sales practices. [2] In 2008, the SEC proposed to regulate (rule 151A) EIA's as securities, over the opposition of state insurance commissioners, who had previously been responsible for regulation. [3] In July 2010, the U.S. Court of Appeals for the District of Columbia ordered that the SEC rule to regulate EIA's be vacated. [4] That same month, the Harkin-Meeks amendment (Section 989J) to the Dodds-Frank legislation denied the SEC regulatory authority over indexed annuities and placed regulation under state law. [5]

A September 2008 study by the Securities Litigation & Consulting Group concluded that equity indexed annuities contain hidden costs, are very complex to understand, and have lower returns than mutual fund investments.[6] A number of this study's conclusions were later refuted in a November 2008 symposium.[7]

The FINRA (Financial Industry Regulatory Authority) has issued an alert on these products, which is listed 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 income 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, Barclays Capital US Aggregate U.S. Index, Nasdaq 100 Index, or Standard & Poor's 500 Composite Stock Price Index.[8]

The insurer offers a minimum guaranteed interest rate (minimum guaranteed return) combined with an interest rate linked to a market index. The guaranteed minimum return is typically at least 87.5 percent of the premium paid at 1 to 3 percent interest.

The specific features of indexed annuities vary from product to product.

Index-linked interest

Questions You Should Ask Your Agent or the Company
  • What is the guaranteed minimum interest rate?
  • What charges, if any, are deducted from my premium?
  • What charges, if any, are deducted from my contract value?
  • How long is the term?
  • What is the participation rate?
  • For how long is the participation rate guaranteed?
  • Is there a minimum participation rate?
  • Does my contract have a cap?
  • Is averaging used? How does it work?
  • Is interest compounded during a term?
  • Is there a margin, spread, or administrative fee? Is that in addition to or instead of a participation rate?
  • Which indexing method is used in my contract?
  • What are the surrender charges or penalties if I want to end my contract early and take out all of my money?
  • Can I get a partial withdrawal without paying charges or losing interest? Does my contract have vesting?
  • Does my annuity waive withdrawal charges if I am confined to a nursing home or diagnosed with a terminal illness?
  • What annuity income payment options do I have?
  • What is the death benefit?
-- NAIC Buyer's Guide To Equity-Indexed Annuities

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. [9] It is essential to understand not only the individual features, but how they work together.

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.[10]

  • 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.

Below are parameters used by the indexing methods to determine the crediting rate:

  • Term: The index term is the period over which index-linked interest is calculated.[11]
  • 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%).[10] [12]
  • 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.[10]
  • 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.[10] [12]
  • Floor: The minimum index-linked interest rate you will earn. The most common floor is 0%. A 0% floor assures that even if the index decreases in value, the index-linked interest that you earn will be zero and not negative.[11]

Some indexing methods utilize these built-in features:

  • 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.[10]
  • Interest calculation: Interest may be calculated as simple or compound. Simple interest calculation methods will result in a lower return than a compounded method.

Exclusion of dividends

Most equity indexed annuities only count equity index gains from market price changes, excluding any gains from dividends, i.e. price 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.[10] Note that this will be less than the return on an investment in a mutual fund tracking that index. Keep in mind that the insurance company does not invest in stocks (which provides dividends) but uses options, which do not provide dividends.

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 can range from as low as 4 to 5 years in some contracts to an excess of 15 years in other contracts.[8]

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.[8]

Any withdrawals from an indexed annuity prior to age 59 and 1/2 will be subject to the 10% federal penalty tax for early withdrawals.

Recovery of investment

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 due to declines in the index, and do not hold the annuity to maturity, you could lose money on your investment (get less back then you invested).

Consider that a guarantee of 87.5% of purchase payments, accumulated at 1% interest compounded annually, would take approximately 13 years for a purchaser's guaranteed minimum value to be 100% of purchase payments.[8] On the other hand, at 3% interest, the purchase price would be recovered in approximately 5 years.

In addition, some insurance companies will not credit you with index-linked interest when you surrender your annuity early.[10]

See also


  1. White Paper, Fixed Indexed Insurance Products including "Fixed Indexed Annuities" and Other Fixed Insurance Products, by The National Association for Fixed Annuities, November 10, 2006.
  2. NASAA Commends Dateline NBC for Helping Expose Questionable Equity Indexed Annuity Sales Practices to Seniors, NASAA news release, WASHINGTON, D.C. April 14, 2008
  3. State insurance regulators are angry about EIA proposal, Investment News, July, 2008.
  4. Some Advisers Dismayed By Indexed Annuity Regulation, WSJ article, July 16, 2010
  6. An Economic Analysis of Equity-Indexed Annuities, September 10, 2008
  7. Un-Supermodels and the FIA, November 11, 2008, David F. Babbel, Wharton School of Business at the University of Pennsylvania.
  8. 8.0 8.1 8.2 8.3 Indexed Annuities and Certain Other Insurance Contracts; Final Rule Federal Register / Vol. 74, No. 11 / Friday, January 16, 2009 / Rules and Regulations
  9. The formulas for crediting interest can be found at Crediting Methods, from Go Figure Now!
  10. 10.0 10.1 10.2 10.3 10.4 10.5 10.6 Equity-Indexed Annuities—A Complex Choice, from the Financial Industry Regulatory Authority (FINRA)
  11. 11.0 11.1 Buyer's Guide To Equity-Indexed Annuities, from the Illinois Department of Insurance
  12. 12.0 12.1 Participation rates and cap rates are subject to change at the discretion of the insurance company, at least partly due to changes in the costs of the insurance company's options hedge as a result of changing market interest rates and changes in market volatility. See 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)

External links



Forum discussions