The ABC’s of Annuity Investing

 

Chapter 4

 

Equity Indexed Annuities

 

 

 

  While there is no ideal investment, there is also no specific type of investment that is always right or wrong. Each investment vehicle has qualities that work well in some specific conditions and qualities that make it unsuitable in others. The goal is to identify the type of investment vehicle that best suits the investor’s needs and goals.

 

  This chapter addresses equity indexed annuities. Like traditional fixed rate annuities, equity indexed contracts are a type of fixed rate contract between the investor and the issuing insurance company. This is a fixed rate product, but it has aspects that are not like the traditional fixed rate annuities. Equity indexed annuities are not variable annuities, but they are more complicated than traditional fixed rate products.

 

  The first equity indexed annuity was offered by Keyport Life in 1995.  At the time it did not receive much attention and relatively few investors utilized it. There were so many other ways of investing that seemed to produce higher returns, which was partially responsible for the disinterest. The complicated nature of equity indexed annuities probably also played a role in the slight attention they received. Following the 9/11 terrorist attack and the collapse of a few major corporations many people realized that their current financial investment vehicles were less than perfect. Mutual funds were plunging down as well as stocks, so even they were no longer perceived as a “safer” form of the stock market.

 

  In 2001 and 2002 equity-indexed annuities began to receive rising investor attention.  It did not take long for sales to move into the billions of dollars.  As a result, many states began to require agents selling annuities to receive training in the mechanics of indexed products.  Few consumers understood how equity-indexed annuities operated so they did not comprehend the risks that were involved.  Unfortunately, even many agents lacked sufficient training in the products.  Like all financial vehicles, equity-indexed annuities can adequately meet a client’s needs or they can be completely wrong for the particular circumstances.  There is no perfect financial vehicle that is right for every person.  Each situation is unique in some way because each investor is unique in some way.

 

  This course cannot and does not completely address all tax issues or all regulatory laws involving equity-indexed annuities.  Our hope is to address EIA suitability questions and offer training for agents who have little past experience with equity indexed products.  At all times tax consultants should be involved to analyze each investor’s personal situation.  It is a foolish agent who attempts to act as both insurance agent and tax advisor to his or her clients.

 

 

Researching the Products

 

  Americans, and really citizens around the world, have become dependent on the internet. We go to the internet for just about everything from household goods to investment products. However, it is important to realize that just about anyone can proclaim their views online; that does not necessarily mean the information is correct or even fairly stated.  While we are not advocating discontinuing the use of the internet it is important that individuals verify the information they receive.  Insurance producers may face obstacles created by the internet if prospective clients have done “research” on their own.

 

  Perhaps the greatest failing of the internet is that it provides an incomplete picture of investing and investment vehicles.  Yes, there is some information provided (some very good information) but it is seldom complete. There is a logical explanation for this incomplete financial picture: it would take a book to completely explain any financial investment vehicle. It simply is not possible to give a total look at a complicated financial vehicle in a few paragraphs or even a few pages of text.  Make no mistake about it: equity indexed annuities are complicated and the choices required of the investor are not always simple.

 

  To make matters even more confusing for the consumer, every author, every agent, and every well-meaning next-door-neighbor claim to be an expert.  Who should the average person believe?  If you are the selling agent, you hope your clients believe you, but it will only take one mistake to convince your clients otherwise.

 

  The wise agent will carry E&O insurance: errors and omissions coverage.  Even a fully educated annuity specialist can make an error or forget to give a vital piece of information. Additionally, even if full disclosure was made, the client may claim otherwise. When it is the agent’s word against his or her client’s the outcome is uncertain. This is also a strong argument for agent documentation. Equity indexed annuities can be confusing, and choices can have adverse consequences. Even when principal is preserved a client who receives zero growth may become unhappy.

 

  The first step is always to realize that although annuities are an excellent financial and safe investment that still does not make them right for every person and every situation.  The length of annuities and the age of the investor are of great importance.  Annuities are designed to be long-term investments, so they are seldom a wise choice for short-term goals.  The Internal Revenue Service considers annuities a retirement vehicle so they will impose a 10 percent penalty on withdrawals made prior to age 59½ (it is an early withdrawal penalty).

 

  If the length of the investment (often up to ten years) and the age of the investor seem to favor annuities, the next step is always to find the annuity product that best fits the investor’s needs and goals.  Your clients may attempt to find the so-called “right” product themselves by going to their computer.  Ninety percent of what they find will be insurers and insurance brokers advertising the products they sell.  There is nothing wrong with that; this is the age of advertising.  Even attorneys advertise now.  Unfortunately, it also means that most of what your clients see will be promoting sales with a company other than yours.  Therefore, only those insurance producers who understand the products and can relay that understanding clearly and precisely are likely to maintain their clients.  The states have various continuing education and/or training requirements, with some states requiring education in equity indexed annuities. While this may sometimes feel like punishment it is actually intended to help all parties involved.  The agent who seeks out education that furthers his or her abilities will benefit and the consumers he or she meets will benefit from the agent’s product understanding.

 

  One important annuity distinction is between fixed annuities and variable annuities.  Fixed rate annuities are underwritten only through insurance companies although banks and other entities may sell them.  In all cases, however, it is an insurer who underwrites and issues the final product.

 

  Variable annuities are classified as securities just as stocks, bonds and mutual funds are.  Although underwritten by insurance companies, variable annuities are offered through securities licensed registered representatives. Simply having an insurance license does not necessarily allow the agent to market variable annuities.  They do not give the same guarantees of safety as fixed rate annuities offer.  Again, equity indexed annuities are not variable annuities; they are fixed annuities.

 

 

Defining the Equity Indexed Annuity (EIA)

 

  Unfortunately, indexed annuities are often thought to be a form of variable annuity, which they are not.  Rather equity-indexed annuities are a type of fixed annuity product.  For this reason, equity indexed annuities are sometimes referred to as fixed equity-indexed annuities. They may be one of the best retirement tools developed in recent years, especially considering how the stock market has. EIAs typically guarantee at least one year of initial premiums returned if the product is held past the surrender period.  Since the indexed annuities have a link to a major stock index, there is the potential of growing faster than a traditional fixed annuity product.  However, their complexity means they are not for all investors.  Any person who does not fully and completely understand how the product works should neither sell equity indexed annuities nor buy them.

 

  Many agents market the unique safety features of EIAs.  No, they are not perfect (as no investment product is), but they can protect the investor from premium loss if the markets crash, while allowing gains if the stock markets perform well.  Like most annuities, these should be considered long-term investments; they often work well for retirement funding.

 

  An equity indexed contract is first and foremost an annuity product.  When annuitized, an annuity can produce an income stream for life or, depending upon the payout option chosen, for a fixed period of time. How funds are received will depend upon the annuitization option selected.  The amount of money received will also depend upon the amount of funds invested in the annuity. It should be no surprise that inadequate investing will mean inadequate income.

 

  Like other annuity products, equity indexed annuities have the same participants.  This includes the annuitant, who may also be the contract owner and the insurance company that issues the contract.  Although beneficiaries will likely be listed on the application, and may be changed as the owner wishes, the intent is always to provide the owner with income.

 

  Although annuities are routinely used for other purposes, the intent is to provide income at a later date, which is why they are often considered a retirement vehicle.  The federal government considers annuities a retirement vehicle and imposes a 10 percent penalty for withdrawing funds prior to age 59½ but of course the funds can be used for any purpose.

 

  Although annuities are issued by life insurance companies, they do not insure against premature death as a life insurance policy would. Annuities do have beneficiary designations, but their intent is not to provide money for heirs; the intent is to provide income during the life of the contract owner. As every agent knows, insurers measure risk. For example, under a life insurance policy, the insurer “loses” if the insured dies prematurely (meaning they pay out funds prior to receiving the time they need to earn a profit) but “wins” if the insured lives longer than expected. In an annuity where a lifetime income is selected, the insurance company retains any undistributed funds at the time of the annuitant’s death. Therefore, under the lifetime annuitization option, the issuing insurance company “loses” if the annuity owner lives beyond his or her lifetime expectation (collecting funds beyond what was deposited into the account) and “wins” if the contract owner dies prior to collecting all the funds he or she deposited.  Unfortunately, many annuitants do not realize (so therefore fail to notify their beneficiaries) that lifetime annuitization selections eliminate beneficiary rights to unused annuity funds.  Since annuity products are intended for contract owners – not their heirs – this should not be surprising, but it continues to be overlooked and unexplained by agents.

 

  As we continue to live longer, we are justified in fearing we might run out of money before we run out of life.  In other words, Americans are at risk for having too little money set aside for the last years of their life.  As we continue to have smaller families we may not be able to count on our children to care for us both physically and financially in our last years. A major cost to our Medicaid system is nursing home care for our nation’s elderly. As our senior Americans spend all they have, they must turn to Medicaid (which is basically medical welfare) for their health care needs.  Few people are saving adequately for their retirement years so annuities, with lifetime annuitization options, make good sense.

 

  As we previously stated, an equity-indexed annuity is a fixed annuity, not a variable annuity.  The investor deposits an amount of money, which the insurer will pay back to the investor at some future date, often through installment payments. It is possible to take a lump sum at contract maturity but that would make little sense. The point of an annuity is to provide income over a long period of time. Taking a lump sum would defeat that goal. Many annuities are never annuitized but they were designed with annuitization as the product’s final phase.

 

  Contract maturity varies by annuity, but most require several years to mature.  Actual surrender penalties can be anywhere from 12 months to ten years or even longer.  When surrender penalties end the contract has achieved contract term.  Withdrawals made prior to term might be subject to insurer penalties, unless a provision allows partial withdrawals. Many contracts allow the interest earnings or 10 percent of values to be withdrawn without incurring penalties. Some annuities reward investors for not withdrawing any funds with bonus interest points if they do not withdraw funds within specified guidelines.

 

  Most equity-indexed annuities are declared rate fixed annuities, meaning the annuity’s rate of interest is re-set each anniversary date. For example, the first year might guarantee an interest rate of no less than three percent; the second year could adjust down or up, depending on current markets. Whatever subsequent years might be, the declared interest rate can never be a negative number. Like all annuities, as long as the investor holds the product to maturity, he or she will receive at least all they paid in; the investor will never lose principal, as can happen in stocks and mutual funds. For many investors, the absolute guarantee of principal is the major reason annuities are chosen for retirement investing.  This might especially be true for those with past experience in the stock market.

 

  While annuity contracts are not all the same, generally EIAs do not have internal expenses, meaning there are no fees, or front-end or back-end loads that could retard the product’s performance. While we must always stress that contracts can and often do vary, most equity indexed annuities have clarity in that what is presented by the insurer is what is actually charged. This is different from variable annuities, mutual funds, and managed accounts that typically have various management fees and expenses.

 

  Typically, equity-indexed annuities are deferred annuity vehicles because they do not begin providing income for several years.  An annuity that begins paying income within a year of contract origin is considered an immediate annuity.  The insurance companies need a period of time to earn a profit and the annuity needs a period of time to earn enough interest to adequately perform. The period of time during which the annuity is growing, earning interest, and perhaps receiving additional deposits from the investor is called the accumulation phase.  Once systematic payments begin (upon annuitization), the contract moves into the distribution phase.

 

  Equity-indexed annuities often allow free withdrawals during the accumulation phase without charging surrender penalties, but it is always necessary to read the contract for details. Depending on the contract, it may be possible to withdraw up to 10 or 15 percent of the account value during the accumulation phase. However, it is important that contract owners realize that any time funds are withdrawn there is less money in the account earning interest. Even so, this can help with occasional financial needs of the investor. If the investor is not yet age 59½ any withdrawals are probably subject to the 10 percent Internal Revenue Service early withdrawal penalty.

 

  Once the distribution phase begins, the annuity’s account value will be declining steadily, as monthly or quarterly payments are made.  Investors typically take distribution payments monthly or quarterly, but many contracts allow semi-annual or even annual payments through the annuitization process.

 

  What we have been discussing is true of all fixed rate annuities so why would an indexed annuity be better than any other fixed rate annuity?  If the stock market crashed or simply underperformed the equity-indexed annuity, like other fixed rate annuities, would simply continue to operate as they always do, paying the pre-set rate of interest on the investment exactly as the contract promises.  However, with an indexed annuity, if the stock market is performing well, the fixed equity-indexed annuity will earn more than it otherwise would.

 

  All EIAs track some specified stock market index, such as the Standard & Poor’s index of the stock values in 500 of the largest corporations known as the S&P 500.  The S&P 500 is a registered trademark of McGraw-Hill & Company.  Whatever index is used if it substantially increases during the term of the equity-indexed annuity, the annuity’s value will increase to the extent specified in the annuity contract.  It would be unusual for the equity-indexed annuity to grow exactly as the index it was based upon.  Most do not tract the index exactly and there are various methods used to correlate gains.  It should surprise no one that some contracts are more generous to the investor than others.  It is important to realize that this added value should be considered a “bonus” since there is no loss if the markets perform poorly. No investor should buy with the expectation that there will always be bonus earnings either.  EIAs are first and foremost a fixed annuity product, but there may be additional earnings if the markets are favorable.

 

  While it may not be so prevalent today, initially equity-indexed annuities were constantly compared to variable annuities. They are not and never were variable annuities.  Critics of equity-indexed annuities may still try to compare them and that does a disservice to the product.  More importantly, it confuses investors.

 

  Variable annuities track the stock market directly, so their values go up and down with the stock market. That is not the case with equity-indexed annuities. Just like all fixed rate annuities, they perform based on the contract with a bonus earning if the index it is based upon performs favorably. Variable annuity values are determined by a separate account that holds various investments, often similar to mutual funds, for each contract owner.  Many allow contract owners to choose their own funds but in most cases it is important that the portfolio be well managed for maximum performance. Variable annuities experience full stock market risk while equity-indexed annuities do not. This distinction should not be taken lightly since it is a tremendous difference in product types. Just as stock market managers are unable to provide long-term financial guarantees variable annuities cannot give long-term performance guarantees either. Experienced money managers may be able to forecast but it is just that: a forecast, not a guarantee. Some variable annuities do guarantee the investor’s return of principal in the case of premature death or during a specified time following the contract’s issue date. A variable annuity has the potential of total loss; that is, the investor could lose the entire amount he or she invested if the market took a dive and remained down. A fixed equity indexed annuity would not be affected by a market dive; the investor simply would not earn any “bonus” earnings. As long as the investor held the annuity contract past the surrender period (maturity date) he or she would receive all principal sums and any guaranteed interest earnings.

 

  Another important difference between variable annuities and fixed equity-indexed annuities are the fees charged.  While every contract can vary, typically variable annuities have several types of fees and expenses, many of which are tied to the buying and selling of stocks.  Obviously, fees and expenses (often referred to in the contracts as management fees) will retard potential earnings. Equity-indexed annuities generally do not have internal fees and expenses beyond what is prominently stated in the contract. Any fees that do exist would be minimal so the investor knows exactly what his or her contract earnings are.

 

  Of course, the wise investor always shops around for the best product.  That is the only way he or she will know if the best annuity has been purchased.  All operating costs (overhead) paid by the insurance company, including commissions, affect the bottom line of their products.  Any type of business, in fact, will be affected by their overhead.  To this extent, commissions may minutely affect interest rates that are guaranteed (it will not affect rates based on market performance in most cases), participation rates, caps and the length of surrender periods.  Since these terms are already set when the product is offered the investor will not get a better contract by bargaining for lower commission rates.  The investor would be wise to shop the marketplace for the best product but that is wise regardless of commissions paid.  Many critics feel agents only present products that pay higher commissions and there may be some truth to this. That does not prevent consumers from shopping around since many available products are offered through varieties of online websites and through local agents.  Since commissions have already been built into each product commission differences may be hard to see.  It would be foolish to get so sidetracked by what agents earn that the important issues of investing are overshadowed: safety of principal, insurer financial stability and satisfaction of investment goals.

 

  Many professionals advise consumers to simply find products that fit their needs and leave commissions between the insurers and their agents. Many elements of how insurance companies determine commissions have nothing to do with the actual product so price shopping, while always advisable, may have no bearing on what the agent receives in compensation. Some insurers pay a higher commission for the same reason department stores pay higher salaries: they want the best people representing them. As it applies to equity-indexed annuities, higher commissions may be paid to compete with management fees financial planners would lose if they recommended EIA products. Financial planners stand to lose a substantial sum over the life of the EIA since they would have made multiple fees if they were managing a mutual fund, for example.

 

  Agents do have an ethical responsibility to represent and recommend suitable annuity products. That is true regardless of the type of annuity being considered. It would certainly be unethical for an agent to recommend a poor product simply because it paid higher commissions. Many states already have implemented suitability requirements for annuities. The National Association of Insurance Commissioners (NAIC) adopted Best Interest requirements, similar to FINRA and SEC, and many states are adopting these requirements because there has been fear that agents might place unsuitable products, especially with older investors who do not have time on their side to recoup losses. Agents who plan to be a career agent are presumably more likely to select product quality over commissions paid. The Best Interest requirements ensure that agents are less concerned with commissions. In fact, under these requirements agents must disclose how they are paid by the insurers they represent.

 

  Annuity suitability and best interest must always be considered. Annuities are long-term investments, so any type of annuity product must suit the needs and circumstances of the investor. For example, most professionals would feel it was unwise to place all an investor’s funds into an annuity (no matter how good the product is). If he or she had an emergency need for cash, there would be none available unless the investor paid an early surrender penalty on the withdrawn funds. Therefore, agents must understand the circumstances of each investor prior to making recommendations. Only when the investor refuses to provide full information is the agent released from his or her ethical obligation to determine product suitability. Even when the investor refuses to supply suitability information, however, agents are obligated to place the best product they can based on the information they have. Best Interest requirements include a form for the investor to sign when they refuse to give required information for an annuity recommendation is the agent released from his or her ethical obligation to determine product suitability.

 

 

EIA Guaranteed Rates of Return

 

  Fixed rate annuities, such as equity-indexed annuities, promise a guaranteed minimum rate of return.  This may be referred to as the “floor” rate since it is the lowest rate that will be paid.  The annuity might pay a higher rate than guaranteed, but never a lower rate.  Higher rates might be paid if market conditions were good.  At each anniversary the minimum rate is re-set, but that would not mean higher rates could not be credited if circumstances warranted it.  In the case of equity-indexed annuities, there is also the possibility of bonus earnings if the market index does well.

 

  Investors must always pay attention to the guaranteed or floor rate since it is the only return that is promised.  Higher rates or bonus returns are not guaranteed.  Some contracts do not give more than a zero-percentage guaranteed rate of return.  In these contracts, there is no guaranteed rate, but the principal is still guaranteed.  In other words, in the worst index situation the investor would not lose their principal but he or she might not gain any interest earnings.  Generally fixed rate annuities (that are not equity-indexed vehicles) would guarantee at least a couple percentage points in interest but equity-indexed annuities do not necessarily do so.  This is another good reason to compare products, although the guaranteed rate of return is only one element of the product and not always the most important.  In some equity indexed products, the investor is better off with a lower guaranteed rate since the contract may offer better participation in the index-linked return if the interest rate is lower – maybe even a zero floor.  The goal is an index-linked return that out-performs the guaranteed rate of return.

 

  How indexed product returns are credited to the annuity contract can be important as well as the actual rate of return earned.  Some contracts may credit guaranteed interest earnings quarterly while others do not credit them until the end of the surrender period (which could be ten years from the date of issue).  If they are not credited until the end of the surrender period, then any penalty-free withdrawals will not have earned even a penny of interest.  It will be as though the funds had never been deposited.  Even if no funds are withdrawn, actual earnings are likely to be lower than a contract that deposits quarterly or even just yearly.

 

  Insurance companies will make early withdrawals unattractive in many cases because the point of buying annuities is for long-term investing. Agents should never deposit money the investor may need prior to the term of the annuity contract. Annuities, including fixed equity-indexed annuities, are not suitable for anyone who may need to make large withdrawals prior to the end of the policy surrender periods.

 

  Most annuity owners and annuitants do not consider how rates are determined or credited; they largely prefer to have their agents select and present an appropriate and advantageous product for them.  Crediting of participation rates can be complicated even for agents who work daily with the products. It might prove very difficult to fully explain the process to consumers.  Despite the fact that it can be complicated, how earnings are credited can significantly affect the end results so it is an important consumer topic.

 

  One might assume that each company will credit all their fixed annuity products the same but that is not always true. Even within each company, different products might credit earnings differently.

 

  Some products will not apply the minimum guaranteed interest rate to 100 percent of the principal.  It is possible that only 80 percent to 90 percent of the principal amount will be credited with earnings.  Some EIA contracts give the insurer flexibility to even change its crediting rates, but most contracts specify certain minimum crediting rates that must be followed.  As with all insurance matters, it is important that the selling agent be fully and completely aware of the products he or she is marketing.  It doesn’t matter how sincere the selling agent was; if a major error is made it is the agent’s fault since he or she had an ethical duty to know the products he or she represented.

 

  If the reader learns nothing else, they must learn this: while most fixed annuity products guarantee against loss of premiums paid in, that is not always the case. Some equity indexed annuities do not make this guarantee of the full amount, guaranteeing only a percentage, such as 90 percent plus whatever minimum interest guarantees exist.  In these cases, if the investor does not receive any index-linked interest there could be loss of premiums.  Of course, if the EIA was surrendered during the penalty period, that could also result in a loss.  Generally, a loss would mean the investor withdrew funds prior to the end of the surrender term.  In these EIA products, withdrawals are not prudent.

 

Know the Facts Prior to Buying

 

  In order to know how interest earnings will be credited, it is necessary to understand how the company credits premiums for the purpose of calculating interest payments. It is also necessary to know if the issuing company has contract limitations preventing them from changing crediting methods. So, first look to see how the insurer credits premiums and secondly, look to see if crediting methods may be changed. This will be found in the policy.

 

  Every agent knows (or should know) the great difference between simple and compound interest.  Simple interest applies only to the principal payments whereas compound interest applies to both principal payments and accruing interest earnings.  In a way, that means that the interest applied in previous periods begins to act like principal, also earning additional interest.  Investors should always seek compound interest products, never simple interest policies.  In fact, a compound interest policy will often accrue more earnings even if it offers a lower rate than a simple interest product.  It will depend on the point spread, but seldom do simple interest vehicles compete well with compound products.

 

  The way an annuity company calculates interest during the policy term will certainly make a difference in the equity-indexed product. Some EIAs might pay simple interest during the term of the annuity but change after that point. Anytime there is no compounding, similar rates of return will mean that the compound interest vehicle did better than the simple interest vehicle.

 

  Some annuities might pay simple interest during an “index term”, when bonus points are possible.  This means index-linked interest is added to the original premium amount but it does not earn compounded interest during the term.  Others may pay compound interest during a term, which means that index-linked interest that has already been credited also earns interest in the future. In either case, the interest earned in one term is typically compounded in the next.

 

  Although most professionals feel it is best to stay with compound interest vehicles, there may be reasons to go with the simple interest vehicle.  Perhaps the simple interest product has some feature the investor specifically wants, such as a higher index participation rate.

 

  Some annuities that are not equity-indexed products will offer bonus rates for one year, maybe even several years. Of course, if the investor surrenders his policy during the surrender period bonus rates will not apply.  Alternately, some EIA products will offer a bonus to an older non-EIA annuity in order to draw in the business to an equity-indexed annuity product. If the bonus makes up for any early surrender penalties it may be worthwhile, but product replacement should never be considered without knowing all the facts.

 

  Sometimes we may see a financial journalist suggest that any annuity bonus inducements are questionable. It suggests, they say, that the insurer has an inferior product and is using the bonus to entice in customers they would not otherwise get. We do not generally agree with this statement, although each product must be individually considered to give an adequate answer. Just as department stores have sales to attract customers, insurers offer bonus points to attract customers. The cost of offering such bonus points is figured in to overhead; insurers are typically very good at analyzing profit and loss. After all, their business is based on risk factors. Although bonuses can give an EIA product a strong performance start, it is important to also look at any limitations on performance that might affect the final returns.

 

  There can always be variations, although all products offered must comply with state and federal requirements.  State requirements can vary so what works in Oregon may not work in Iowa or Minnesota for example.

 

  If withdrawals are made, even if there is no surrender fee applied, it is likely that the amount withdrawn will not be credited with interest so this should always be considered prior to pulling money out of an equity-indexed annuity.  Of course, withdrawals made prior to age 59½ will incur an early distribution charge from the IRS as well.

 

 

Index Crediting

 

  There are various fixed equity index annuity products.  The differences can be important as they apply to crediting.

 

  Interest crediting provides a minimum return; index crediting provides the potential of a maximum return at the end of the term because it is measured in some specified way with the chosen index.  Although interest guarantees can be zero, it is likely that at least some amount of interest earnings may be guaranteed, even if only one percent.  If an investor was only interested in the guaranteed rate of interest earnings there would probably be no point in depositing funds into an equity indexed annuity contract; a traditional fixed annuity product would be sufficient.

 

  The National Association of Insurance Commissioners (NAIC) has published a buyer’s guide for equity-indexed annuities. Although there are more elements to these products than just the potential maximum return, since consumers will be looking for products that produce greater returns, it is likely that this element is often the characteristic focused on.

 

  The NAIC does not endorse any company or contract; their publication is intended to help the general consumer understand equity indexed annuities so that they may make the most prudent choice for their particular circumstances.  Their publication states:

 

“What are equity-indexed annuities? An equity-indexed annuity is a fixed annuity, either immediate or deferred, that earns interest or provides benefits that are linked to an external equity reference or an equity index.  The value of the index might be tied to a stock or other equity index. One of the most commonly used indexes is Standard & Poor’s 500 Composite Stock Price Index, which is an equity index.  The value of any index varies from day to day and is not predictable.”

 

  Like all annuities, equity indexed annuities are insurance products and are issued by insurance companies.  The buyers of these products are not directly purchasing stocks.

 

  There are two very important aspects to equity indexed annuities: the indexing method and the participation rate.

 

  Equity indexed annuities are fixed annuities, either immediate or deferred.  They earn interest or provide benefits that are linked to an external equity reference or an equity index.  The index value will be tied to some particular index, such as stocks, often the S&P 500 Composite Stock Price Index.  This would be an equity index.  The value of any index changes often, perhaps daily or even hourly.  The changes cannot be predicted, so there is growth risk involved, although the principal is not at risk.

 

  The indexing method is the method used to measure the amount of change in the index.  While there is not necessarily going to be change, change is likely.  The most common indexing methods are annual reset, also called ratcheting, high-water mark, and point-to-point.  The original EIA used only a single method, usually the S&P 500.  There are now many ways to calculate contract values.

 

 

Participation Rates

 

  Participation rates can be a limitation on the base interest rate paid by the issuing insurance company.  They can also limit the index-linked return.  Since participation rates are primarily a function of equity indexed annuities consumers do not typically have experience with them and may lack understanding of an important product feature.

 

  A participation rate will determine how much the gain in the index will be when credited to the annuity. How gains will be credited can be confusing. The annuity company may set their participation rate at various amounts (depending upon the product); for example, it may state a participation rate at 80 percent, which means the annuity would only credit the owner with 80 percent of the gain experienced by the selected index (the S&P 500 for example). If the calculated change in the index is 9 percent and the participation rate is 70 percent, the index-linked interest rate would be 6.3 percent. This is figured by multiplying 9 percent times 70 percent, equaling 6.3 percent.

 

  Participation rates for newly issued annuities can change daily. As a result, initial participation rates will depend upon the date the insurance company issued the annuity.  Participation rates are usually guaranteed for a specified period of time so additional deposits may receive the same rate as the initial deposit.  When participation rates are guaranteed, they may range from one year on.  It is always important to check the actual policy since products do vary.

 

  Once the product period ends, the insurer will set a new participation rate for the next period.  Some annuities guarantee that the participation rate will never be set lower than a specified minimum or higher than a specified maximum.

 

  Participation rates offering less than full value (100 percent) protect the insurers in some situations and may allow them to offer higher interest rates or caps. It may surprise consumers to learn that sometimes it is better to select products with less than full value (80 percent to 90 percent perhaps) to earn higher rates of interest. Although critics may imply that less than full participation rates are a product disadvantage, in fact they are often beneficial.

 

  The NAIC states participation rates vary greatly from product to product and even from time to time within the same product. It is certainly important for agents to fully understand how they work but consumers also need a basic understanding of them. A high participation rate may be offset by other features, including simple interest, averaging, or point-to-point indexing methods. Conversely, an annuity company may offset a lower participation rate while offering a valued feature such as an annual reset indexing method.

 

  An important note: some EIA contracts allow the insurer to change participation rates, cap rates, or spread/asset/margin fees either annually or at the start of the next contract term.  If an insurer subsequently lowers the participation rate or cap rate or increases the spread/asset/margin fees, returns could be adversely affected.

 

 

Averaging

 

  Some equity-indexed annuities average the index (called averaging) based on the indexed-linked returns during the entire period rather than simply subtracting the beginning point from the end point.  Averaging can protect consumers from index crashes or greatly fluctuating indexes.  As is always the case in averaging, the highs and lows are smoothed out.  While it does smooth out the peaks and valleys, there is the risk that some return will be lost, especially if highs outnumber lows.  Averaging methods will vary; some companies average daily, while others average monthly.  Many professionals in the industry believe that averaging could reduce earnings. Additionally, they state understanding the complicated methods used to calculate gains in the index the annuity links to can be very difficult.  Returns vary more than a traditional fixed rate annuity but not as much as a variable annuity (equity indexed annuities are not variable annuities; they are fixed annuities).  Because of the minimum guaranteed interest rates EIAs have less market risk than variable annuities.

 

 

Caps

 

  Some equity indexed annuities have caps.  In other words, returns are capped or limited.  Usually caps are stated as percentages; these are the highest rates of interest that can be earned.  If the product’s index gained 9 percent but the cap was set at 6 percent, then 6 percent would be the most the investor could earn.  Not all equity indexed annuities will have a cap, but it is something that agents and investors must be aware of.

 

  Caps absolutely do affect how these products perform but that doe not necessarily mean investors must totally avoid them. Annuities with caps may have other features the investor wants, such as annual interest crediting or the ability to make penalty-free withdrawals. Caps often allow insurers to offer other benefits, such as higher interest rates. A professional agent will help the investor to decide whether it is better for their particular situation to have higher participation rates or higher caps.

 

  The most common caps are annual caps and monthly caps but products vary so agents must view each contract individually.  Some contracts allow the issuing insurer to change caps based on specific market conditions. If this is the case, investors need to be aware of this ability.

 

 

Spreads, Margins and Administrative Fees

 

  Some products will deduct a percentage from the gains in the form of various fees.  The percentage could be in addition to or in lieu of participation rates or caps.  The fees may come under different names, such as spread, margin or administrative fee.  These are not the only names it may come under, but they are the most common.  The fees may be in addition to or instead of a participation rate. For example, an EIA might charge a 2 percent per year spread from the index-linked return. Figuring the cost over time can be difficult or at least complicated, but over ten years, with the index performing at an average of 12 percent per year, there would be a 2 percent loss, so earnings would be 10 percent rather than 12 percent.  This is a simplification, but it does give the reader an idea of how it works.

 

 

Returns

 

  Equity Indexed annuities will be linked to such things as the stock market, but that does not mean returns will directly reflect a stock market purchase. EIAs are linked to the performance of the index – not to the actual stocks that the index is based upon. As a result, the annuity does not give credit for dividends that could have been reinvested if the actual stocks had been purchased. Most equity indexed annuities only count equity index gains from market price changes, excluding gains from dividends. An investor who is not earning dividends will not, therefore, have the same gains he or she would have if he or she had directly invested in the stock market. On the other hand, the investor also will not experience some of the losses that would have occurred with directly investing in the stock market. Those who oppose investing in EIAs will point to this potential loss of growth, while those who support EIAs will point to the protection from principal risk. The investor is trading the dividends that might have occurred for their safety of principal. There is no investment that will be ideal. High risk means potential high loss; low risk means less earnings.

 

  Most equity indexed annuities use something simple, such as the S&P 500 and do not take into account reinvested dividends. While the loss in value of reinvestment of dividends can be significant, especially over a number of years, those who invest in these types of annuities are typically more concerned with the safety of their principal and are, therefore, willing to earn less. Even without reinvested dividends, indexes still perform pretty well. EIAs usually they do better than certificates of deposit or bond rates, although that is certainly not guaranteed.

 

  It should never be assumed that every client will appreciate the benefits of equity indexed annuities, especially if higher earnings are important to them. It is always a question of suitability and risk.  Those who want higher earnings will probably not be happy with EIAs; such investors will probably want to benefit from dividends for example. Some advocates argue that the loss of reinvested dividends is offset by the annual reset (ratchet) annuities that credit the index return with only a zero in negative years. However, many feel it is unwise to push any investor into any vehicle that they seem unsure of.

 

  There are variables in equity indexed annuities; all products are not identical. For example, an EIA that is back-tested does not ensure financial performance.  Back-testing means that the annuity was tested against historical returns, perhaps as far back as twenty years.  Future performance will not always mimic past performance.  We have seen our markets change dramatically and they are likely to remain unpredictable.  Additionally, there is no guarantee that the back-testing is reliable since reliability is often determined by those doing the testing.

 

  Back-testing can help to illustrate the annuity, so it is not without merit.  However, agents and investors must remain aware that past performance does not guarantee future performance.  Professionals generally prefer the use of Monte Carlo analysis, which uses multiple samplings of random hypothetical market returns. This may present a more accurate visualization of the product and will not leave a false impression of how the annuity is likely to perform.

 

 

Indexing Formulas

 

  Equity-indexed annuities credit earnings differently than other fixed rate annuities.  Where traditional annuities state a rate of interest and then apply those interest earnings at specified intervals, an EIA calculates its return against the index to which it is linked.  This is called the indexing method.  Equity-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 earned, is calculated and credited.  With traditional fixed annuities, interest gains are always earned, although how they are credited may vary.  EIAs do not necessarily have interest gains, since they are based on the indexing method. The indexing method, or formula, decides how the additional interest, if any, is calculated and credited.  The amounts earned, and when they are paid, depend on the contract features.

 

  There are multiple formulas for indexing, with new methods appearing regularly.  As a result we will not attempt to describe indexing formulas. New methods often are developed with the hope of attracting consumers, but in the end the amount earned is going to depend upon the performance of the index that is used. Even professional analysts cannot accurately speculate on market performance over several years and annuities are long-term investments.

 

  Many investors find having multiple equity-indexed annuities, with each using a different indexing method, advantageous. By purchasing EIAs that use different indexing methods, the investor is likely to end up with good average performance between the various annuities. Additionally, many investors consider having multiple EIAs as a means of diversifying their annuity portfolio. Some indexing methods work better under some conditions, and worse under others. Diversification prevents being affected adversely with no other annuity investment to offset the adverse conditions.

 

  Some of the new equity-indexed annuities allow several indexing methods. The designated indexing method on these annuities can be changed at certain times, usually on anniversary dates.  These allow consumers to select their indexing method at the time of purchase.  Some of the newer EIAs allow consumers to use several indexing methods simultaneously, allowing investors to do with one contract what usually requires several to achieve.

 

  Some equity-indexed annuities will allow the investor to see their progress (or lack of it) at specific times, usually annually. These annuities have “reset” features that lock in gains on some specific basis, such as once per year so that the investor knows whether he or she gained during the year.  Generally, EIAs held to maturity do not lose principal, but that does not mean it is guaranteed to have gains.  Other equity-indexed annuities do not have the ability to see what returns are until the EIA has run its entire term, which may be many years after purchase.  Investors who want to be able to view their returns should choose a reset product.

 

 

Annual Reset Indexing Method

 

  For investors wishing to see their returns annually the annual reset indexing method is typically the best choice.  Annual reset EIAs usually look at the index at the end of each contract anniversary date and locks in gains made as of that date. This is called the annual reset method or may be referred to as the ratchet method.  Under this method the gains posted at the end of the year (or at whatever point is in the contract) will remain even if the index goes down later.  The ratchet method compares the changes in the index from the beginning to the end of the year, with declines being ignored.  The advantage is a gain that is locked in each year.  The disadvantage is the possibility of lower cap rates and participation rates that might limit the amount of available gains.

 

  Under annual reset methods it is possible that there will be no gains.  If the index declined from the previous year, the contract simply credits zero for that period.  In the next contract anniversary year, there is then no place to go except up. The previous period’s end value for the index (not the annuity value) is used as the starting point for the new period, meaning that each period is looked at individually.  It does not matter whether there were gains in previous contract years and will not matter in coming years what gains, if any, were given in the current year. Although there may be a lower contract cap rates and participation rates, investors choose this method for the locked in gains, meaning current profits will not be lost to bad years that may come in the future.  Even if the stock market were to crash, any past gains are retained in the annuity values.

 

  Investors often do not mind the lower cap and participation rates because they feel they will be offset by the fact that negative years result in zeros rather than value losses.  While we would all like to see our investments increase in value we also do not want to lose values.  A zero gain is better than an investment loss.

 

 

High Water Mark Indexing Method

 

  Another indexing method is the high-water mark method. It compares the index at various periods during the contract to the index level at the beginning of the term.  Although the time periods can vary, typically the contract’s anniversary date is the time measure used.  The high-water mark indexing method takes the highest of these values and compares it to the index level at the start of the term. While the investor may be credited with more interest under this method than other indexing methods and receive protection against declines in the index, the disadvantage is that the investor may not receive any index-link gain at all if he or she surrenders their EIA early.  That is because interest is not credited until the end of the contract term; if the contract is surrendered early, the contract term was not reached. Some of these contracts will still give the investor interest based on the highest anniversary value to date under a vesting schedule.  Some high-water mark indexing contracts might impose lower cap rates and participation rates.  As always, it is important for investors to know and understand all policy terms.  Certainly agents must know this as well.

 

  If it were not for participation rates and caps, the high-water mark indexing method would give investors the highest risk-adjusted returns of any indexing method, but of course there are caps. It is also important to realize that only the highs reached at the comparison periods count (usually policy anniversary dates).  If a high is reached midway they will not apply.  For example:

 

A contract is issued on June 1, 2016.

On June 1, 2017, the index had increased by 12 percent.

On December 15, 2017 the increase rose to 42 percent.

By June 1, 2018 it was down to 10 percent.

 

  Because only the anniversary dates apply, the 42 percent index rate will not apply.  Over the next ten years of the product’s term, the percent at the anniversary date will be calculated. At the end of the ten-year term, the investor will receive the highest point recorded on an anniversary date during the term of the contract, up to any applicable participation or rate caps.  It is not unusual to have a participation rate that is less than 100 percent.

 

 

Point-to-Point Indexing Method

 

  The point-to-point indexing method compares the change in the index at two distinct points in time, such as the beginning of the contract and the end of the term.  Although the investor may enjoy a higher cap and participation rate, which credits more interest, the disadvantage is that it relies on a single point in time to calculate interest.  As a result, even if the index that the annuity is linked to is going up steadily during the contract’s term, if it happens to decline dramatically on the last day of the term, then part or all of the earlier gain can be lost. Since gain is not credited until the end of the term, the investor may not receive any index-link gain if the policy is surrendered prior to the end of its term.

 

  To recap, the point-to-point index-linked interest, if any, is based on the difference between the index value at the end of the term and index value at the start of the term.  Interest is added at the end of the annuity’s term.

 

  Even though point-to-point contracts offer the potential for the best long-term returns the disadvantage is the inability to gauge the contract’s performance until the end of the contract’s term, which could be anywhere from five to ten years. Until that time, the growth will appear to be zero even if the market is significantly up.  If the annuitant dies during the term, for purposes of measuring contract performance, the date of death will be used as the end of the term.

 

  The point-to-point method may be best for the longest-term EIAs since we can expect the best gains over the longest period of time.  However, since the ending value is based upon that specific point in time, a sudden or unexpected downturn could prove detrimental to the contract’s final value.

 

  Some point-to-point indexing contracts charge a spread, stated as a percentage, per year.  Others may limit participation to less than 100 percent or impose caps. The contract may limit or alter the way the means of crediting based on point-to-point. They may use the end point to average the index over the term of the contract and credit interest on a compounded basis based on the average rate, less some stated percentage defined in the contract.  As always, all contracts should be fully understood by the selling agent and the investor.

 

 

Multiple EIAs with Diversified Indexing Methods

 

  Diversification is not a new idea; agents and professional planners have been advocating that for years.  Annuities may also be subject to diversification, which is something many investors may not have previously considered. Obviously, we cannot know in advance which annuity indexing method will perform best over the coming years but investors who purchase several types of annuities are bound to average out their earnings.  This is especially true of equity-indexed annuity types.  Some indexing methods will do better in volatile markets and others will do best in steady markets.

 

  Many professionals feel the indexing methods of the EIAs are not nearly as important as other issues and features, such as selecting highly rated insurance companies.  While this is true, it is still important to understand the indexing feature chosen.  Also important is choosing a product with competitive interest rates, participation rates, caps and other features.  By purchasing several different EIAs with several different features the investor may minimize lower earnings due to market trends.  Even professional investors realize that it is not possible to guess which indexing feature will perform best in the coming years, since it will depend upon how the markets perform. Therefore, buying different annuity products with different indexing methods is a good way to diversity within the annuity market.

 

  Whatever annuity products are selected, they should be purchased from different insurers so that there is diversification of insurance companies.  Of course, all companies should carry no less than an A rating from A.M. Best company.

 

 

Withdrawing Annuity Funds

 

  Most insurance agents are probably familiar with the “income for life” ability of annuity products.  Under this method, the investor can select to receive income for the duration of his or her life; they have an income that they cannot outlive.  However, there is no guarantee as to the actual amount of lifetime income.  Obviously if the investor saves too little in the annuity product, the amount of income stream may be very small (too little to actually support their income needs).  Therefore, the first and most important aspect of saving is to save adequately. Still saving something is better than saving nothing, so even if the individual knows the amount, they are setting aside is inadequate that does not mean he or she should abandon saving altogether.

 

  Ideally each citizen should begin setting aside money from the time they first receive a paycheck, regardless of how young he or she may be.  Parents are wise to encourage the act of saving a percentage of income from the very first check a child receives for his or her birthday or other occasions from Grandma and Grandpa.  Establishing this financial trait is one of the most important gifts a parent can bestow upon their child since it sets up a habit that will benefit their children for the remainder of the child’s life.

 

 

Payout Options

 

  Annuities are designed for pay-out after age 59½ since the Internal Revenue Service considers them to be retirement designated vehicles. They may still be used for other goals, but primarily they are considered retirement vehicles.  Although annuities were designed for payout, they are overwhelmingly used for accumulation.  In other words, the majority of annuities are not annuitized (turned into an income stream).  Instead most investors accumulate funds in their annuity, and then simply withdraw the entire value or exchange it tax-free for another annuity, with the accumulation process starting over again.  Often annuities are simply left intact year after year, eventually going to heirs.

 

  Even though most annuities are not annuitized for systematic payout, it is always important for agents and their clients to understand the available payout options.  When annuities were created the issuers assumed lifetime income would be primarily used.  They were designed to pay a specified amount, based on the total dollars in the annuity, for the remainder of the annuitant’s life, regardless of how long he or she lives.  Under this arrangement, beneficiaries receive nothing even if the annuitant happens to die soon after annuitizing the contract.

 

  For example:

 

  Annie Annuitant and Alvin Annuitant each have an annuity in their name of equal value (for this example let’s say each annuitant has $50,000 in their annuity). Annie and Alvin both choose lifetime income when they annuitize their contract and each receives the same amount each month.  Just to keep it simple, we will say that each Annuitant receives $1,000 per month (the actual figure might be far different, based on the age of each Annuitant and their “life” expectancy).

 

  Alvin begins receiving his $1,000 per month on January 1.  In June of that same year he becomes very ill, eventually dying three months later in September. Alvin received a total of nine annuity payments totaling $9,000.  The remainder of his annuity ($41,000 plus accrued interest) will stay with the insurer that issued the policy; Alvin’s heirs will receive nothing.

 

  Annie also begins receiving $1,000 per month on January 1 just as Alvin did.  However, Annie Annuitant lives to a very old age.  She eventually receives every penny of the $50,000 in her annuity, but she continues to receive the $1,000 monthly payment even though her own funds have been depleted (that’s what “income for life” means).  By the time Annie eventually dies she has received $75,000 from her annuity contract.  As a result, the insurance company paid out $25,000 more than it received.  However, the company also retained $41,000 from Alvin so the insurer still made a profit based on these two people. 

 

  Insurance companies use analysts to determine expected longevity of their policyholders because their goal is always to earn a profit.  While it is not possible to know for sure how long each person might live, there are indicators that suggest the likelihood of longevity.  Alvin’s beneficiaries are likely to be unhappy about the loss of the remaining $41,000 but Annie’s family will be very happy to see how her annuity paid out.

 

  Once an annuity contract is annuitized it cannot be changed; the annuitant or policy owner cannot change their mind down the road. Usually the point of no return is when the first annuity payment is cashed, or if a direct deposit is used, the date the check is deposited.  Each contract may vary so it is important to consult the actual policy for details. Since the payout option is locked in agents must be certain their clients understand the advantages and disadvantages of each payout option.

 

  Annuities may not necessarily offer all payout options.  If a particular payout option is important to the buyer, he or she will want to specifically examine the available payout options listed in the policy.  Any questions should be addressed prior to purchasing the annuity.

 

 

EIA Safety

 

  One of the first investment considerations must be the entity selected to deposit funds with.  Whether the investor is buying an annuity, a Certificate of Deposit, or simply opening a Christmas club account, the sponsoring organization’s financial strength (or lack thereof) should be considered.

 

  When selecting an annuity product, the sponsoring organization is always an insurance company.  Whether the product is bought at the investor’s local bank, from an insurance agent, or just online annuities are always issued by an insurance company.

 

  For equity indexed annuities, once the product is past the surrender period the only way to lose money is if the sponsoring insurance company becomes insolvent.  Obviously no investor wants to be with an insolvent company.  Guaranteed return is only as good as the entity sponsoring the investment; in the case of annuities that would be an insurer.  Luckily most annuity insurance companies do not become insolvent, but it can happen.  Historically annuity companies seldom fail.  Other investments are far more likely to experience insolvency than annuities.  As a result of the rareness of annuity insolvencies even critics of annuities seldom mention the possibility.  Even so, it is important to utilize only financially secure insurers because even a very small chance of failure is important.

 

  There are distinct differences between variable annuities and equity indexed annuities.  EIAs are not backed by segregated reserves or specific assets, as variable annuities are.  The EIA investor does not own the index, index shares, or stocks comprising the index.  Equity indexed annuities are contracts. EIA investors own those contracts, which promise to pay money in the future from its general assets. Sound familiar? That is basically what life insurance policies are: contracts that promise to pay funds in the future if the insured dies during the term of the policy.  Although equity indexed annuities are not life insurance products, they are both contracts promising future payments.  EIAs are backed by the assets of the annuity company (not just specific assets or specified pools of assets), which explains why it is very important that only financially secure companies be selected.  EIAs are roughly comparable in their safety to money-market funds according to Jay D. Adkisson, author of Equity-Indexed Annuities: the Smart Consumer’s Guide.

 

 

A Comprehensive Financial Plan

 

  It is unlikely that any one type of financial vehicle would be sufficient to comprise a fully adequate financial plan.  Equity indexed annuities must be part of a portfolio that considers all types of investment vehicles so that the investor’s goals and aspirations are fully satisfied.  Assets must be logically divided among several types of financial vehicles so that the investor’s full needs are met. An agent or financial planner that merely divides the client’s assets among an array of annuities, even if diversified among several indexes and annuity types, is probably not doing an adequate job of protecting his or her clients.  Generally, it takes several types of investments to appropriately address possible future returns and investment risks.

 

  Most annuities (with the exception of variable annuities) are considered safe financial investment vehicles. Equity indexed annuities could be classified with cash and equivalents such as Certificates of Deposit and money market accounts because they are made up of fixed annuities, which are traditionally safe. The risk is small that the investor will not receive at least the minimum returns. While we would all like to see huge growth, safety of principal is typically the primary concern. The biggest risk is not loss of premium (principal) but rather that the growth will be too small to match or exceed the rate of inflation.  It is possible that loss of buying power could occur with annuities.  In other words, while the principal is maintained the interest earned is too small to maintain the same level of buying power ($100 may only buy 80 percent or $80 of what it once could buy).  This is the same risk that all conservative financial vehicles face. Lower financial risk also means lower rates of interest earnings, so lower rates of growth.

 

  Fixed annuities promise a guarantee that a certain amount will be available at some point in time (depending on contract terms) but they do not promise that the returns will keep up with rates of inflation. Even though equity indexed annuities are not liquid financial vehicles, they do promise that at least the principal will be available at some specified date.

 

  Many investors like to “ladder” their investments, with some coming to maturity each year during retirement or at least during the early years of retirement. Many investors stagger their investments to reach maturity in five-year increments. The goal is to provide continual income during retirement; as one investment is used to fund retirement costs, the next investment matures and takes up where the last investment ended.

 

For example:

 

  Rachel Retiree has given lots of attention to her retirement planning.  She has Social Security income, which is too small to live on, but no pension from her working years. Knowing that she would not receive a pension she saved regularly throughout her working years. With the help of a financial planner she knows approximately what her living costs will be in retirement.  The only unknown factor was the rate of inflation so she tried to have more than she thought would be necessary available from her investments. If inflation is greater than anticipated she hopes the “extra” will cover the rising costs of living. On the other hand, if inflation is not as great as she thought it would be she will have extra funds, which of course is what Rachel is hoping for.

 

  In year one of her retirement a Certificate of Deposit matures and is used to fund the first five years of Rachel’s retirement. 

 

  In the fifth year of Rachel’s retirement, a fixed rate traditional annuity is annuitized to provide monthly income for the next five years.  Because it will pay out all funds over just a five-year period Rachel will actually be able to put part of the income into a liquid savings account to cover unforeseen emergencies, such as health care needs or dental costs.  This expectation of extra funds may not materialize if inflation soars but if it does not she will be over-funded.  Although she could use the extra money for travel or other pursuits Rachel is wise enough to realize the future may cost more than the present.

 

  In the tenth year, when Rachel is 72 years old (she retired at age 62 when she could begin collecting Social Security benefits) an equity indexed annuity matures.  This annuity promised better returns than her traditional fixed rate annuity so she chose to have it mature when she was older.  She felt it may give her more income at a time when living costs would possibly be higher due to inflation.  By this time she also hopes her modest stock investments will have grown sufficiently to produce any additional funds that she might need for such things as higher insurance premiums on her health insurance or medical needs associated with growing older. Rachel knows she took on an extra risk when she chose not to buy long-term nursing home insurance. She felt she would not be able to pay the potentially rising premium rates of such insurance. Rachel hopes she will not need nursing home care even though historically she is likely to, if just from the frailty that comes with aging (especially for women who make up the majority of nursing home residents).

 

  In the 15th year of Rachel’s retirement, when she is 77 years old, her final investment will be utilized, a bond fund.  Obviously, Rachel does not know how long she will live but Americans continue to live longer than those before them.  It is certainly possible that Rachel could live to be 100 years old. She can only hope her money will last as long as she does.  Rachel could have chosen lifetime income from her annuities to guarantee funds for as long as she lives.  She chose to receive income for shorter periods of time because she felt lifetime payments would be too small to cover her expenses. Rachel can only hope she made the best choices for herself.

 

  While equity indexed annuities might be classified with cash and cash-equivalents because of their high level of safety they tend to offer some advantages:

 

  It is easy to see why professionals who are familiar with equity indexed annuities might choose them over CDs and money market funds.  Still most people tend to keep more money in certificates and money markets than they do in EIAs, probably because so few people really understand and appreciate the features of equity indexed annuities.

 

  Agents may sometimes see equity indexed annuities compared to some types of bonds.  Investment returns may be similar, although most bonds do not enjoy the tax deferral that annuities enjoy.  Even so, if withdrawals may be needed before the EIA would mature bonds are a better choice for the investor.  However, if liquidity is not a concern, it is typically better to invest in the equity indexed annuity because:

 

  This does not mean that bonds have no place in the investor’s financial portfolio since they do offer liquidity that is not available in annuity products. Bonds are used for liquidity and EIAs are used for long-term performance. Bonds might also be the investment choice if funds will be needed prior to age 59½ since annuities would be subject to IRS early distribution penalties for withdrawal prior to that age. As we previously noted, it is always an issue of product suitability.

 

  There is another difference between bonds and equity indexed annuities: investors cannot wait for EIAs to decline in price and then buy them.  Since bonds can go up and down in price, investors might wait for bond prices to go down before they buy them.  Equity indexed annuities can only go up in value and have only positive correlations to the asset classes that overlap the index the product is linked to.

 

  Agents and financial planners may sometimes want to compare equity indexed annuities to mutual funds or index shares.  Mutual funds are vehicles made up of various stocks.  Index shares are stocks that track the index.  EIA critics often do not like that the annuities limit participation in returns if the index rises.  It is true that the investor would do better with mutual funds and index shares if the index goes up, but what if it goes down?  Investors that want to enjoy guarantees typically realize there is give-and-take when it comes to lowered market risk.

 

  EIAs are subject to participation rates, caps and other limitations.  Utilizing equity indexed annuities should not mean anticipating higher gains than those stated; instead the investor should only consider the minimum guarantees.  Higher gains are merely a plus to the diversified portfolio.

 

  Mutual funds typically have fees and expenses that affect the final performance.  That does not mean they should not be part of a diversified portfolio, but product costs should be considered.  Mutual funds carry risks besides fees; managers are not always the best or a good manager may not remain.  Managers may take excessive risks, putting the funds in a position to take a loss.  Mutual funds are not necessarily tax efficient.  Most equity indexed annuities do not have fees or expenses and do not experience annual taxation.

 

  For some investors who track the index mutual funds may be their investment of choice but generally a well-rounded portfolio is best.  That means having some of many different investments, including annuities.

 

 

Grasping Fundamental Aspects of the Product

 

  In all cases with all investments the investor (buyer) must understand what he or she is purchasing.  If the selling agent is a good communicator he or she is probably able to educate the buyer sufficiently.  However, sometimes even good communicators are not able to explain a product in a manner the buyer understands.

 

  Any time an agent suspects the buyer does not understand the product caution should be used. A buyer who does not understand what they have purchased is likely to experience buyer’s remorse. Although annuities come with what is called a “free look” period when he or she can return it for a full refund it is still dangerous for the agent to place any product the buyer does not fully comprehend. Sometimes it can even result in lawsuits. Lawsuits are most likely to happen when the product does not perform as the buyer expected it to.  Sometimes lawsuits are filed not by the buyer, but by his or her family members so it is important that the buyer fully appreciate their investment and relay why it was purchased if necessary.

 

  Consumers buy things every day but most purchases can be touched, felt, and shown off.  When a new car is purchased the family members might not agree with the purchase but at least they understand the reason for buying it. An equity indexed annuity is not likely to be shown off as a new car would be. The buyer may have every confidence in his decision but if his children become involved it could change to “the agent took advantage of my aging father.” We are not suggesting that older investors not be allowed to purchase an equity indexed annuity; all ages have a right to invest in any fashion they wish. We are advocating that agents take extra time going over the aspects (both good and bad) of the annuity if there is any doubt whatsoever that the product may be misunderstood or if there appears to be lingering doubts about how the product functions.

 

  Equity indexed annuities can be complex, especially to an individual without past annuity experience.  Even agents can misunderstand some of the EIAs characteristics, so it stands to reason that many investors will be learning about the product for the first time.  Clear communication is vital to an investor being happy and confident about the purchase they have made.  Obviously, it is necessary to disclose all pertinent information about the product prior to the sale.  This is true of all annuities, not just equity indexed annuities.

 

  There always seems to be so-called financial experts that do not agree with the annuity concept. Many of these individuals are more interested in selling their books than actually educating the public, but if it causes your clients to doubt their purchase it won’t matter if the author actually knows anything about EIAs. The only way to prevent your clients from doubting their purchase is to explain the product well enough for the buyer to remain satisfied with their decision. He or she must remain satisfied even if his or her children question their buying decision; satisfied enough to ignore the so-called experts hoping to sway the investor to their personal investing views.

 

  There are elements of EIAs that agents must completely communicate prior to placing the product. Some basic information is always important:

  1. The name and contact information of the issuing insurance company;
  2. The name and contact information of the selling agent;
  3. The financial rating of the issuing insurance company;
  4. The length and amount of the surrender penalties (policy term);
  5. The point at which the insured will reach age 59½ and no longer have to be concerned with IRS early distribution penalties.

 

  In addition to the basic information listed above, equity index annuity investors need to know:

  1. The minimum guaranteed rate of interest gain;
  2. The participation rate for interest crediting;
  3. How the annuity is linked to the index;
  4. The participation rate for index crediting;
  5. Any caps that exist in the contract;
  6. How the insurer will treat the annuity if the insured dies (are surrender charges waived for example);
  7. Are there exchange options?  If so, what are they?
  8. Can the insurer change some terms in the contract (often called the “moving parts”)?  If terms can be changed, specifically what may be changed?  Insurers can typically change guaranteed interest rates at specified points, but there may be other terms that are changeable as well.
  9. Tax consequences that may apply to the annuity must be known, such as taxation as ordinary income when funds are withdrawn.  There may be tax matters that are specific to an individual so agents are wise to suggest buyers consult their personal tax accountant.

 

  There may be additional points the agent feels is important to discuss with their clients, but the list we have supplied is typically always addressed for equity indexed annuities.

 

  Equity indexed annuities are primarily regulated by the individual state insurance departments with some differences in regulation existing among the states.  Even so, the states primarily have similar requirements. Equity indexed annuities are not subject to SEC regulation since they are not securities.  Therefore, EIAs are not subject to customer suitability, disclosure and sales practices requirements that registered securities must meet.  Several states have, as we said, passed “suitability” requirements for annuities however and EIAs would fall under any such suitability standards the state may have.

 

 

Terminology for a Complex Product

 

  Most agents are accustomed to specific product terminology but equity indexed annuities are not like the traditional fixed rate annuities so there may be terms the agent is not already familiar with, but that are very important to know.

 

Adjusted Change: The change in the Index Value for a segment, with adjustments as described in the indexed interest rate provision.

 

Annual Reset Indexing Method: Index-linked interest, if any, is determined each year by comparing the index value at the end of the contract year with the index value at the start of the year.  Interest is added to the annuity each year during the term.

 

Annuity Benefit: The payments that may be made under the “benefit on annuity commencement date” of the contract.

 

Averaging: Some annuities use an average of an index’s value rather than the actual value of the index on a specified date.  The index averaging may occur at the beginning, the end, or throughout the entire annuity term.

 

Beneficiary/Beneficiaries: The person or people entitled to receive death benefits if the annuitant should die prior to withdrawing all annuity funds, unless annuitized for a lifetime benefit, in which case beneficiaries receive nothing even if the annuitant did not use all premiums deposited.

 

Cap or Cap Rate: Some contracts will state an upper limit, called a cap, on the index-linked interest rate.  This is the maximum rate of interest the annuity will earn.  It is the highest Adjusted Change for each segment of the indexed strategy.

 

Code: The Internal Revenue Code of 1986, as amended, and the rules and regulations that are issued under it.

 

Commencement Date: if an annuity benefit is payable; the death benefit commencement date will be shown on the contract specifications page.

 

Contract Anniversary Date: the date each year that is the annual anniversary of the contract effective date, shown on the contract specifications page.

 

Contract Year: A contract year is each twelve (12) month period that begins on the contract effective date or on the contract anniversary.

 

Death Benefit Commencement Date: the first day of the first payment interval for a death benefit that is paid as periodic payments or the date of payment that is paid as a lump sum if periodic payments will not be made.

 

Death Benefit Valuation Date: Although contracts may vary, typically the Death Benefit Valuation date is the earlier of:

  1. The date that the insurer has received both Due Proof of Death and a written request with instructions as to the form of death benefit (lump sum or systematic payment); or
  2. One year form the actual date of death.

 

Due Proof of Death: Due proof of death is typically one of the following:

  1. A certified copy of a death certificate, or
  2. A certified copy of a decree that is made by a court of competent jurisdiction as to the findings of death (this is generally only used when the person or person’s body cannot be located). Companies may accept other types of proof in some circumstances.

 

Floor: The lowest Adjusted Change for each segment of an index strategy is called the “floor.”  It is the lowest point on equity index-linked interest.  It is the minimum index-linked interest rate the investor will earn.  The most common floor is 0 percent (zero).  While that looks like a bad thing, it actually assures that even if the index decreases in value, the index-linked interest will not go negative, losing money. Yes, no interest would be earned but neither would any principal be lost. Not all contracts have a stated floor on index-linked interest rates but fixed annuities will have a minimum guaranteed value.

 

High-Water Mark Indexing Method: The index-linked interest, if any, is decided by looking at the index value at various points during the term, typically the yearly anniversary date of purchase. The interest is based on the differences between the highest index value and the index value at the start of the term.  Interest is added to the annuity at the end of the term.

 

Index: An index is the specified index that will apply to an Indexed Strategy for the term shown in the equity indexed annuity contract, usually on the specifications page.  If the index is no longer published or its calculation is changed, the insurer may substitute a suitable index at their discretion. Insurers should notify their policyholders if a substitution is made. Sometimes the insurers are required to first get approval of the substitution from the state insurance department.

 

Index Value: The index value is the standard industry value of the index. The index value for a particular date is the value of the index as of the close of business on that date.  For any date that the New York stock Exchange is not open for business, the index value will be determined by the insurer and stated in the policy, but often it is the index as of the close of business on the most recent day on which the Exchange was open prior to that date.

 

Indexing Method: The indexing method is the approach used to measure the amount of change, if any, in the index.  Some of the most common indexing methods include annual reset, or ratcheting method, high-water mark method and the point-to-point method.

 

Index Spread: An amount by which the Index Change is reduced when computing the Adjusted Change.

 

Index Term: The index term is the period over which index-linked interest is calculated.  In most product designs, interest is credited to the annuity at the end of the term, which may be ten years although the average term is more likely around seven years.  Products may offer a single term or multiple consecutive terms.  Those with multiple terms usually have a window at the end of each (generally 30 days) during which the policyowner can withdraw his or her funds without penalty. For installment premium annuities, the payment of each premium may begin a new term for that premium.

 

Index Value: The standard industry value of the index is the index value. The index value for a particular date is the value of the index as of the close of business on that date or the most recent date the Exchange was open.

 

Interest Compounding: Some annuities pay simple interest during an index term.  That means index-linked interest is added to the original premium amount but it does not compound during the term. Others pay compound interest during a term so that the index-linked interest that has already been credited earns additional interest.  In either case the interest earned in one term is usually compounded in the next however.

 

Participation Rate: The participation rate is the portion of the index change that is used to compute the adjusted change.  It decides how much of the increase in the index will be used to calculate index-linked interest.  It is the portion of the index change that is used to compute the Adjusted Change. Note the definition of “adjusted change” above.  Participation rates are typically guaranteed for stated amount of time, but the company will change the rates after that time.

 

Point-to-Point Indexing Method: The index-linked interest, if any, is based on the difference between the index value at the end of the term and the index value at the start of the term.  Interest is added to the annuity at the end of the term.

 

Segment: Segment is the period of time over which the change in the index is measured for an indexed strategy.  A segment may never be longer than the term of that strategy.  The initial segment begins on the first day of the term.  Subsequent segments begin upon the expiration of the preceding segment.  Daily segments that end on a day that the New York Stock Exchange is closed are often disregarded.

 

Term: For a declared rate strategy, the period of time during which the interest rate is declared; for an indexed strategy, the period over which an indexed interest rate is calculated. The initial term begins on the first interest strategy application date.  Subsequent terms begin upon the expiration of the preceding term.

 

Valuation Date: A date on which the index value is measured to compute the Index Change. If an indexed strategy uses valuation dates that are daily, then dates on which the New York Stock Exchange is closed are disregarded. If an indexed strategy uses valuations dates that are other than daily, the valuation dates are the dates within a month that correspond with the first day of the term.

 

Vesting: Some annuities do not credit any of the index-linked interest, or only part of it, if the investor withdraws their money before the end of the term.  The percentage that is vested, or credited, generally increases as the term comes closer to its end and is always 100 percent vested by the end of the term.

 

 

General Contract Provisions

 

  All contracts have general provisions. In life and annuity insurance policies the general provisions establish what might be called the “ground rules.” The following is a sampling of what might be seen in an equity indexed annuity policy.

 

Entire Contract

 

  The contract must be identified.  It might state something similar to: “This Contract is an individual deferred annuity contract. It provides for both declared and indexed interest rates. It is restricted as required to obtain favorable tax treatment under the Code. This contract, any riders or endorsements to it, and the application for it, if any, form the entire contract between the owner and the issuing insurer.”

 

Changes and/or Waivers

 

  The contract is always the final word on the terms and conditions of the annuity.  Agents do not have any authority to make changes or waive any part of the contract.  The policy will state this in wording similar to the following:

 

  “No changes or waivers of the terms of this contract are valid unless made in writing and are signed by the insurer’s President, Vice President, or Secretary.  No other person or producer, including the writing agent, has any authority to change or waive any provision of this contract. The insurer reserves the right both to administer and to change the terms of this contract to conform to pertinent laws and government regulations and rulings.”

 

Misstatements

 

  We usually think of misstatements in terms of age but it can relate to any misstatement.  Some errors affect the performance of the policy while others have little effect.  Often misstatements change the premium cost of the policy but annuities typically do not have this concern since they are based on the amount earning interest, usually not the age of the insured.  In some cases, age does have a bearing however since many annuities will not issue coverage to anyone above a specified age. Misstated age can also affect the amount of systematic payments upon annuitization since age is a major factor in determining projected length and amount of those payments.

 

  Most policies address the issue of misstatements.  In an equity indexed annuity it might read similar to the following:

 

  “If the age of a person is misstated, payments shall be adjusted to the amount that would have been payable based on the correct age.  If payments based on the correct age would have been higher, we (the insurer) will immediately pay the underpaid amount in one sum, with interest, at the rate of __% per year.  If payments based on the correct age would have been lower, we (the insurer) may deduct the overpaid amount, with interest at a rate of __% per year, from succeeding payments and pursue other remedies at law or in equity.”

 

  Of course, the interest rate will be filled in, but for our example we felt it best to leave it blank.

 

Required Reporting

 

  The state insurance departments probably have some requirement for notifying clients of changes in policy status or earnings.  Policies will state how often such reports will be issued to their policyholders.  Generally, companies notify at least yearly of changes that will affect their policyowners.  The policy will state how reporting may be expected.  It might read similar to the following:

 

  “At least once each contract year, we (the insurer) will send you a report of your current values.  We (the insurer) will also provide any other information required by law.  These reports will stop on the earliest of the following dates:

  1. The date that this contract is fully surrendered;
  2. The annuity commencement date; or
  3. The death benefit valuation date.

 

  The reports will be mailed to the policyowner’s last known address.  If permitted by law, in lieu of that we may deliver these and other required documents in electronic form.  The reported values will be based on the information in our possession at the time that we prepare the report.  We may adjust the reported values at a later date if that information proves to be incorrect or has changed.”

 

State Law

 

  Certainly, states may have laws in place that affects how the annuity contract may be written and laws change from time to time. It stands to reason that insurance companies must follow whatever laws are in place and any laws that come after the contract was written, if they affect the contract. There is likely to be some statement in the equity indexed annuity regarding state laws; it may read similar to the following:

 

  “All factors, values, benefits, and reserves under this contract will not be less than those required by the laws of the state in which this contract was delivered.”

 

Claims of Creditors

 

  Some states will better protect against creditors than others. Your annuity will follow whatever the state dictates by law. It may be stated as the following: “To the extent allowed by law, this contract and all values and benefits under it are not subject to the claims of creditors or to legal process.”

 

  The important part of that statement is “to the extent allowed by law.”  At any point creditors become an issue the insured should obtain legal advice from a competent attorney that specializes in contracts or consumer law.  Since laws do sometimes change the policyowner should not rely on information obtained at an earlier date.

 

Other Contract Items

 

  There will be other items covered in most contracts, such as Exclusive Benefit (who may benefit from the contract), liability issues, tax issues, incontestability and transfer by the company. In all cases, agents must be fully aware of the products they are representing and selling. Of course, applicants have a responsibility to fully read the contracts but as every agent knows, they seldom do.  Instead they rely upon their agent to fully disclose all facts and figures.

 

  Even when an insurance producer believes he or she has fully disclosed all relevant facts and features of the product, there is no way to keep the information fresh in the buyer’s mind.  Since agents do not want lawsuits simply because the consumer forgot what he or she was told it is the wise agent who delivers the policy personally and goes over the features a second time.  It is a very wise agent who obtains the buyer’s initials on all key points within the policy.  This can be done on a separate paper or form that the agent keeps in the client’s file at the producer’s office.  Having the policy initialed is fine as long as the agent has access to it in case of a lawsuit, but that is unlikely.

 

 

Additional Payments

 

  Some equity indexed annuities will allow only one initial payment; others will allow additional payments.  Too often insurance producers do not think to inquire whether buyers might wish to make additional payments in the future.  It is an important question to ask since the buyer might simply assume he or she can do so.

 

  When a contract allows additional premiums (deposits) it will specifically state so.  The heading might vary but should say something similar to “Purchase Payments” or “Additional Premium Payments.” If additional premium payments are allowed it will state something similar to the following:

 

  “One or more purchase payments may be paid to us (the insurer) at any time before the annuity commencement date, so long as you (the buyer) are still living and the contract has not been full surrendered or annuitized.”

 

  Since annuitization locks in payments it would not be possible to make additional payments once annuitization was initiated.

 

  Most equity indexed annuities have minimum premium deposit requirements.  Many have a $10,000 initial deposit requirement, but that can vary even among policies of the same company.

 

  Some contracts may offer a purchase payment bonus.  If so, it will be specifically stated in the contract.

 

 

Surrender Values and Penalties

 

  Equity indexed annuities have surrender penalties just as traditional fixed annuities do.  The policy will state the terms of the surrender periods.  This is an important part of the contract and should not be minimized.

 

 

New Developments in Indexed Products

 

  Insurance companies are constantly developing new products.  Sometimes they may be revisiting past products with new twists; other times the product seems completely unique.

 

  For example, climate has always presented a challenge to farmers, herders, fishermen and others whose livelihoods are closely linked to their environment, particularly those in poor areas of the world.  Index insurance now offers significant opportunities as a climate-risk management tool in developing countries, according to a publication issued in Geneva. The report, called Index Insurance and Climate Risk: Prospects for development and disaster management is part of the Climate and Society series produced by the International Research Institute for Climate and Society. It was published in partnership with the United Nations Development Program, the International Fund for Agricultural Development, Oxfam America, Swiss Re, the US National Oceanic and Atmospheric Administration and the World Food Program.

 

  For poor people, a variable and unpredictable climate can critically restrict livelihood options and limit development. Banks are unlikely to lend to farmers if they think a drought will cause widespread defaults, even if the farmers could pay back loans in most years. The farmers' lack of access to credit limits their ability to buy improved seeds, fertilizers and other inputs.

 

  Index insurance products represent an attractive alternative for managing weather and climate risk because it uses a weather index, such as rainfall, to determine payouts.  This resolves a number of problems that make traditional insurance unworkable in rural parts of developing countries.  With index insurance contracts, an insurance company doesn't need to visit the policy holder to determine premiums or assess damages.  Instead, if the rainfall recorded by gauges is below an earlier, agreed-upon threshold, the insurance pays out.  Such a system significantly lowers transaction costs.  Having insurance allows these policy holders to apply for bank loans and other types of credit previously unavailable to them.

 

  However, if index insurance is to contribute to development at meaningful scales, a number of challenges must be overcome.  For example, some efforts to implement index insurance failed due to lack of capacity, institutional, legal and/or regulatory issues, lack of data, and other constraints.  The new publication looks at the technical and operational challenges that currently limit the growth and spread of index insurance.  It highlights a number of case studies of the various applications of index insurance across the world thus far. Among them are:

 

  There are sure to be other ways indexed products develop and change over time. We often think the insurance field is stationary but that simply is not true.  Without insurance development and change many of the businesses that exist today would disappear.

 

End of Chapter 4