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Index Linked Fixed Annuities (“EIA”)
The index linked fixed annuity is commonly referred to as an equity index annuity, or just EIA. When this annuity was introduced it was linked to an equity index only and thus the reason for the name. As the index linked concept has matured the choice of indices has been expanded to include fixed rate, or bond, indices as well as numerous equity indices, e.g., S&P, DJIA, Wilshire 2000, NASDAQ, and others. It is important to know that the premiums from an EIA is not generally invested in equities or bonds, but rather the earning opportunity is dependent upon the movements in the index to which it is linked.
The exact link between the earning potential of the EIA and the index to which it is linked can vary widely among issuers and even annuities issued by the same insurance company. The method used to compute the earnings of the EIA is referred to as the “crediting method” and each method has its own unique set of terms and conditions. In fact, at this time there are over fifty different crediting methods in use and the number continues to expand.
One of the most popular crediting methods is called the annual point to point annuity and its growth is typically linked to the S&P 500. It works as follows: at the time of the initial premium, the level of the S&P is recorded as the starting point and compared to the level at the first anniversary of the initial premium. The difference is measured and used to determine the amount of the earnings paid into the annuity for the first year. This movement in the S&P may be subject to a participation rate, a cap and possibly a spread. Since EIAs are fixed annuities, the owner is always guaranteed some minimum rate of return even if the index movement is negative over the period. There are also EIAs that will guarantee a certain minimum increase in the index crediting even if the index movement is negative. This guaranteed “index increase” is generally available only for a fee or some other limiting provision incorporated into the annuity’s design.
The participation rate is the amount of the movement in the index that the annuity owner is entitled to have credited to the annuity as earning. The participation rate is generally less than 100%. However, in some cases it is stated as 100% participation in an “average”, or a “cumulative average”, which in mathematical terms is less than a 100% participation rate in the change of the index “point-to-point”. The reader should be aware that the use of “100% participation rate” is based on an “averaging method” or may be subject to a “maximum cap”. There are a few EIA that tout participation rates in excess of 100%; however, these levels may be “marketing hype” as they also have caps, spreads and/or employ an averaging technique to compute the credited earnings. Participation rates are generally higher if an averaging technique is used in the crediting method and lower for point-to-point. Also, point-to-point methods are more likely to employ caps than are the averaging methods. The best way to understand EIAs is by examples.
- Assume the index used is the S&P 500 and this index increases 12% during the year, but the participation rate is stated as 80%. In this case the annuity would be credited with an earning rate of 9.6% (80% of 12%). If the participation rate was given as 100% but with a 9% cap, then the amount credited would be 9% since that is the maximum permitted, or the cap. Sometimes both participation limits and caps are used to determine the earnings credited.
Also, some EIAs employ a fee, generally called the “spread”, which is subtracted from the earning rate before it is credited to the annuity. In the foregoing example, if the spread were 2% the annuity would be credited with 7.6% (9.6% less the 2% spread) and 7% (9% less 2%), respectively. The participation rates, caps and spreads may be fixed for a specified time or they may be guaranteed for the term of the annuity. Generally, if they are subject to being reset at the option of the issuer, they will also have declared minimum and maximum amounts that limit their variability. The only way to determine the variables in an EIA is to carefully analyze it and if there is still confusion you should (a) abandon using that annuity or (b) consult with a financial planning professional to ascertain the exact terms and conditions.
Commonly used crediting methods include the point-to-point which may be monthly, one-, two- or even three-year(s) in length, the monthly average, the cumulative monthly average with a high water look back and ad nauseam. Parenthetically, the high “water mark look back”, or just high water mark, refers to the value being locked in at the highest point during its term if such a point exceeds the minimum guaranteed return. This means that early gains can be “locked in” when the index loses value. Most EIAs guarantee that the annuity value will not decline during a period when the index falls but rather be zero, increase by the guaranteed minimum amount or be the previous high water mark.
The important thing to remember about crediting methods is that any one has a chance of being the best or worse before the fact. Since all are linked in some fashion to a movement in an underlying market-determined index that cannot be predicted with accuracy, there is no way to know exactly which one will perform best until after the time period has run. Nonetheless, many people seem to believe that one, or a few, crediting methods are superior to all others with the annual point-to-point reset being the most popular.
At this time the EIA is rapidly becoming the best selling “brand” of fixed annuities as it is promoted to offer unlimited upside potential with no downside risk. EIAs are oftentimes characterized as variable annuities with air bags that protect the annuity owner from market crashes. Since the EIA offers downside protection in the form of a minimum guaranteed rate of return if held to term and participation in the increases of the index to which it is linked, it is the ideal conservative investment for the retirement minded saver that cannot afford loss. The limit on the upside participation is the price, or premium for no-loss insurance, that the owner pays to become immunized against downside risk. This value-proposition of no downside in exchange for limited upside has substantial appeal to savers guarding retirement funds or those near retirement who cannot afford to gamble with their savings. The popularity of the EIA has been bolstered by the recent-year gyrations of the equity and bond markets that have left conservative savers and investors with substantial losses in mutual funds, stocks, bonds and variable annuities.