March 2011

MARCH 2001: What You Need To Know About - Equity Index Annuities

Author: Lew Wessel | Photographer: Photography by Anne

Snooze alert! Okay. I know this isn’t the most exciting subject, but you should know about this investment, because sooner or later, some financial person is going to pitch an Equity Index Annuity (EIA) to you and it’s going to sound really, really compelling—not Nigerian millions compelling, but pretty darn sweet. Here’s what you need to know about them:

OVERVIEW
In an earlier article, I covered annuities and neglected to include equity index annuities. My bad, if only because they do represent about 13 percent of total annuity sales in the United States per AnnuitySpec.com’s Indexed Sales & Market Report (2009).

In that earlier article, I explained that annuities come in two basic forms: immediate and deferred (when they distribute monies) and deferred annuities are further divided into fixed and variable (how and where your investment is invested). An EIA is regulated and behaves most like a deferred fixed income annuity, but it offers the seductive promise of the possibility of market-related gains with a guarantee of minimal or no losses. Who wouldn’t want that? But remember what you learned in kindergarten: “If it sounds too good to be true…”

IT’S COMPLICATED
“Complicated” is the word you’ll find most often when you research EIA’s. FINRA, the financial industry’s main independent regulatory authority, headlines its section on EIA’s with “Equity-Indexed Annuities—A Complex Choice” and goes on to say that investors will find it very difficult to compare and evaluate one with another. I’ll do my best here to explain the parameters, but, if you are going to invest in one, be prepared to do a lot of research.

THE INSIDE SCOOP
The basic EIA promise is to provide the investor with a tax-deferred investment with a no-loss guarantee—a minimum return of zero—coupled with the possibility of earning a higher rate of return based on the movement of some equity-related index. Your EIA is not actually invested in stocks, but rather is “linked” to the movement of an equity-related index. Your account is then credited with a portion (see below) of the upward movement of that index. If the index goes down, your account stays level—the “no-loss” guarantee. The most common index used is the S&P 500, but almost any index can be found as an option in EIA contracts, including the Hang Seng Index, EUROSTOXX, Russell 2000, etc.

So does that mean that if the S&P 500 increases 15 percent in one year, your contract value will also increase 15 percent? The answer is an emphatic “NO”. And here’s why:

In every EIA contract, the upside potential of your equity-linked return can be limited by a hodge-podge of factors. These include one or more of the following, alone or in combination:

• Participation rate. This is the percentage of the index gain that will actually be credited to your account. If the participation rate is 80 percent and the S&P 500 index goes up 10 percent, your increase would be limited to eight percent.

• Spread or margin rate: This is the amount that will be subtracted from the index before calculating the actual credit to your account. If the “spread” is three points and the index goes up 10 percent, your account will only be credited with seven percent.

• Cap rate: This is the maximum rate your account will be credited no matter how high the index goes. In other words, if the cap rate is, say, eight percent and the market duplicates a year like 2009 where the S&P 500 index increased 24 percent, your account will only be credited with an eight percent increase.

Sound complicated? We’re just getting started! Another factor in the EIA contract is exactly how the movement in the linked equity index is measured in order to determine the gain that will be credited to your account.

Some of the many crediting methods offered are:

• Annual point-to-point: The gain measured is the change in the index from the beginning to the end of the contract year. This gain is then subjected to the caps, spreads, etc. above and the account is then credited. If there is a loss, the “gain” is zero percent. In most cases, the index is reset at the end of every year, so the account has a good chance to make a gain after a down year.

• Monthly point-to-point: The gain measured is the monthly point-to-point changes. The ups and downs of each 12 months will be added together to determine the net upward movement at the end of the year. The catch here is that often the monthly upward movements are capped at say 2-4 percent while the monthly downward movements are not capped. Thus, one or two bad months in an otherwise stellar year can wipe out all gains.

• Monthly and daily averages: Here, the crediting method involves averaging monthly and daily numbers and then subjecting the calculation to a predetermined cap, spread and/or participation rate.
Each of these crediting methods may be optimal, depending, unfortunately, on 100 percent hindsight into the behavior of the underlying index. Suffice it to say, FINRA is indeed correct in warning that determining whether one EIA contract is better than another is extremely difficult if not impossible.

SURRENDER CHARGES
An EIA is, at its core, an insurance contract, and, therefore comes with a “surrender period.” This is the amount of time you have to keep your money in the contract before you can start taking it out without penalty. I’ve seen as long as 14 years on an EIA contract. Suffice it to say, this should only be considered as a long-term investment.

BOTTOM LINE
The key with EIAs, as with any financial product or investment, is to understand what they are and what they can do for your overall portfolio. EIAs are considered “fixed annuities” by regulators and I think that is a fair categorization.

They certainly fluctuate considerably less than a true variable annuity. EIAs generally offer a no-loss guarantee, or at least a base return of principal guarantee that’s close to it—the “standard non-forfeiture value.” That’s a terrific thing when the market is in free-fall (In case you have forgotten, the S&P 500 fell 38 percent in 2008). On the flip side, as shown above, the upside of an EIA is usually severely limited and would be a very poor choice in an extended bull stock market. Thus, for the conservative investor or for the conservative portion of a person’s portfolio, EIAs may have a place.

It should also be mentioned, as with all deferred annuities, that there is no tax on the earnings of an EIA until funds are withdrawn, and EIAs can be “exchanged” tax-free at a later date for an immediate annuity to generate a lifetime income stream.

GUARANTEED MINIMUM WITHDRAWAL BENEFIT (GMWB)
As discussed in my previous article on annuities, GMWB are “riders” or add-ons to annuities, including EIAs. This rider offers, for an extra fee, an additional value in the EIA that has a guaranteed growth rate and a future guaranteed lifetime pay-out once the contract holder begins to take distributions. For the investor looking to establish a “personal pension,” the GMWB rider can be a terrific choice.

FEES
As with any investment or insurance contract offering guarantees, fees are involved. In the case of the EIA, these “fees” are primarily in the form of the caps, spreads and participation rates described above and in lengthy surrender periods. These “fees” allow the insurance companies to offer no-loss guarantees and some upside equity-related returns by investing upfront in long-term bonds and equity-linked options.

CONSULT YOUR ADVISOR
Every financial article has to end with “consult your advisor”, but if, after reading this article, you didn’t realize the importance of sound, professional advice when contemplating the purchase of an EIA, then shame on you and me!

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To comment or for more information, e-mail lewwessel@hargray.com.

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