Understanding Equity-Indexed Annuities

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Recently, a client asked us about potentially buying an equity-indexed annuity (EIA). Not to be confused with a variable annuity, an EIA is not held in a “separate account” of an insurance company exclusively for the policyholder’s benefit. Instead, it is backed by the general assets and the reserves and surplus of the insurance company from whom it was issued. The particular product this client was considering had the following features:

  1. 5% premium bonus,
  2. Ten-year surrender charge period that starts out at 10% and stays there until the third anniversary,
  3. A “credited interest rate” that could be based on a choice of stock indexes such as the S&P 500, the Russell 2000, or the Nasdaq 100.

One major selling feature of these products is that the principal is guaranteed along with a minimum amount of interest, and for this particular contract, the principal plus 5% would be guaranteed at the end of ten years. This product also offers a rider (at an annual cost of 1.2% of principal) to guarantee a minimum credited interest rate of 5%, but that credited rate is only applicable if the funds are ultimately used to purchase an immediate annuity from the same company. This would limit the client from having the ability to shop different companies to find the best combination of annuity payout rate and company reliability.

One problem with EIAs is that they can be very difficult to understand. There are myriads of different methods of calculating the credited rate of interest such as changes in “point-to-point” values or changes in “monthly average” values of the underlying index with either a "cap" (a limit to the level of the percentage gain in the index that would be credited) or a "spread" (a fixed amount that would be subtracted from the percentage gain in the index). With some products, only a percentage of the increase in the index is credited. This percentage is commonly referred to as the "participation rate".

For somebody considering one of these products, it is important to understand what the insurance company does with the premiums. After paying the agent his commission (which can be 10% of the premium or higher according to annuityiq.com and what creates the need for a surrender charge), the remainder is placed in reserve (as is legally required to ensure that the guaranteed payments to the policyholder are met). This reserve is usually invested in low-risk bonds, and part of the interest received from those bonds is used to buy call options to capture the promised upside of the market. If the market stays flat or goes down, the options expire as worthless and new options are purchased with the bond coupon payments received in the interim. For someone who feels comfortable trading options (which we do not recommend) it is usually possible to replicate the stream of payments that is promised by the insurance company and avoid the surrender charge, which can be a significant source of profit to the company. The other primary source of profit is the spread that the company earns on investment of the premiums over the minimum guaranteed credited rate of interest.

A few years ago, the Financial Industry Regulatory Authority (FINRA) issued an investor alert on EIAs. They noted that the guarantee is only as good as the insurance company that gives it, and they warn potential buyers that, “if you surrender your EIA early, you may have to pay a significant surrender charge and a 10 percent tax penalty that will reduce or eliminate any return.” Another very important point brought forth by FINRA is that the index returns are usually calculated without the benefit of dividends, and those dividends would have been fully captured by an investor who bought a fund based on the underlying index. Here is, perhaps, the most important point expressed by FINRA:

“Caution! Some EIAs allow the insurance company to change participation rates, cap rates, or spread/asset/margin fees either annually or at the start of the next contract term. If an insurance company subsequently lowers the participation rate or cap rate or increases the spread/asset/margin fees, this could adversely affect your return. Read your contract carefully to see if it allows the insurance company to change these features.”

For the EIA that the client was considering, the cap for point-to-point crediting can be raised or lowered annually but is guaranteed to never go under 1%. For the monthly average crediting method, the spread can be raised or lowered annually but is guaranteed to never go over 12%. For both crediting methods, a 100% participation rate is guaranteed for the life of the contract.

Unsurprisingly, we advised this client to take a pass on the EIA. IFA’s advice is that if you want the opportunity to capture the gains of the stock market, then it is better to take a direct equity position in accordance with your risk capacity. Furthermore, if you want a guaranteed income for life, then please consider either a single premium immediate annuity or a deferred income (longevity) annuity from a highly-rated insurance company.