The Equity Indexed Annuity (EIA) is not only a new product; it is a somewhat complicated product that is extremely unusual. For starters, it is an insurance product that determines the annuity payments by the use of an index that is “geared” to the fluctuations of the stock market. So far, it is still considered as “insurance” and not as security, therefore an insurance-only agent can market the plan, and a securities license is not needed (although it may be recommended as described later in the discussion). This text will explain how the product is devised and how it is used correctly, and the education thus afforded may help to keep the product out of the regulation of the Securities and Exchange Commission because of misuse or misrepresentation by insurance agents.
FThe Equity Indexed Annuity is NOT a security, and should never be directly compared to a security (stock, bond, etc.)
In particular, this product offers a unique planning opportunity for financial planners. However, there are many provisions and elements of this new product and many new options and changes are introduced with regularity.
It must be stressed that a financial planner that uses the Equity Indexed Annuity as part of a planning process, should be very familiar with the product offered by the particular company that he/she represents, and also familiar with products offered by other companies. In most cases, insurers have done a creditable job of providing information regarding the products that they offer, including seminars and training courses.
Terminology is important with this product, as being a new product it has introduced new words and new definitions of existing words, into the vocabulary of the financial community. In this text are results of surveys among those professionals who market EIA’s and it is readily apparent that unless a person had some knowledge of the product, there is no way that they could understand the statements made by these professionals.
FAn Equity Indexed Annuity is, simply put: a fixed deferred annuity.
It is not a new type of annuity, it is not a security, it is not a Variable Annuity – it is a fixed deferred annuity with all of the guarantees and features. The biggest difference between an EIA and a “regular” fixed deferred annuity is how interest is credited to the contract.
Traditionally on a fixed annuity, the interest rate credited to the annuity is based on existing and current interest rates which is guaranteed by the insurance company and is guaranteed payable for the term of the annuity. Since most fixed annuities use a one-year period, they are renewed for another year, one year at a time. While it may have a guaranteed interest rate of, typically, 3 percent, it will use current rates each year, but never less than the guaranteed rate.
With an EIA, the interest rate is based on a formula linked to an independent stock market index – usually Standard & Poor’s Composite Stock Price Index (S&P 500). So, to summarize: an Equity Indexed Annuity is a fixed deferred annuity that uses an external index that reflects the fluctuations of the stock market to determine the interest earned.
The EIA is not a security, indexed mutual fund, nor an investment in the stock market, nor a Variable Annuity; it is also NOT a substitute for any of these investment vehicles. However:
FThe conservation of the principal of the Equity Indexed Annuity is GUARANTEED!
(Blaring of trumpets, rolling of drums, resounding applause of thousands of investors….)
Remember that it is a fixed annuity. A fixed annuity protects the annuitant from the risk of losing their invested money (principal) because of the vagaries of the stock market. This is the safety factor that has made fixed annuities attractive throughout the years and which are then used for “safe” investments that will not be accessed for a period of years. Remember also, as stressed throughout this text, risk and return work in tandem – as the risk increases, the return increases. Therefore, the security of a fixed annuity would indicate that the return would be provided at a low rate of return.
With an EIA, the investor is provided with an opportunity to share in increasing rates because of increasing values in the stock market, and still do so with a guarantee that the principal will not be touched. It can be used to provide the annuitant with a steady stream of income, and can be used to supplement other income like Social Security, pension plans and income from savings.
The EIA was introduced first in the late 1980’s but not marketed successfully. Neither the product nor the company is still in existence. In 1994 two companies reintroduced the Equity Indexed Annuity. In 1996, $1.4 billion in premium was sold, in 1997, it went to $3.5 billion, and in 1998, it was $5 billion. The 1999 figures are not available yet, but it has been estimated as approaching $15 billion. Today, there are more than 80 different products from more than 40 companies.
As this product is dissected in this text, the question will usually arise as to why there are so many and varied forms of EIA’s. There are a variety of reasons that are the result of experience of the market, the marketing effort, the customer’s viewpoint, and the home office concerns.
There are a variety of means used by insurance companies to measure the movement of the index used by the company, and each method is responsible for some form of variation. Since the assets of the insurance company “guarantee” the returns, including the guarantee of the “minimum”, the portfolio containing the reserves for these products must mirror or closely imitate the index at any particular time. As experience in persistency, for instance, becomes more valid, the length of time that the assets must be invested becomes more apparent.
This is a new product and any new product is the result of the “best guess” of the marketing staff, the investment and underwriting philosophy of the carrier, and the product creation by the actuaries based on their assumptions. Rarely has any insurance product (or most any product) been so perfect when first introduced that no changes were necessary later.
Although rarely discussed publicly, there is continued concern by the insurance companies as to whether the product will be considered as a “security” by the SEC, which would require much additional administration, compensation methods, securities licensing of their sales people and the general headaches connected with dual regulation – the State Department of Insurance, and the Federal Government’s Securities and Exchange Commission.
Probably the most significant changes come as a result of input from the marketing area. If the product does not sell, all of the expertise and expense available is of no consequence. The customer tells the agent/financial planner as to what they want and what they need, plus any reason that they do NOT want to purchase the product.
Then, of course, arguably as important as marketing input, is the actual fluctuation of the market. As noted later in this text, the various types operate best when the market is performing in a particular manner. When this product was first introduced the stock market and other investments were behaving much differently than they are today. What appealed to a certain class of customer at that time is probably much different today.
Competition plays an important role in developing types of EIA’s, as it does in the development and revision of all products. Since two companies introduced the plan in its present basic form, and that has expanded to around 40 companies now, it is self-evident that competition was involved. It should be pointed out that any time an insurance company introduces a new product, it must go through a lengthy period of approval by various Departments of Insurance, and during this period of time it cannot make any changes of any type. If it does make even minor changes in most cases, it will have to resubmit the plan for approval all over again, causing another delay. In the meantime, another company can create a “better” plan and submit it to another Department.
Indexing is nearly as old as the stock market. The government and industries use the Consumer Price Index (CPI) as a method of measuring goods and services used to measure inflation.
Some of the most brilliant of actions seem so elementary in retrospect that one must wonder why no one else had thought of it before. In the mid 1970’s, a company that markets mutual funds, decided to “index” the mutual fund by buying the same stocks as the Standard & Poor’s 500. Other mutual funds followed, as later did banks and financial institutions that offer financial products. While actually the Standard & Poor’s 500 Index is an “index”, it is also an industry guideline that measures stock prices of 500 leaders in their particular industries. Therefore, to “mirror” the index, invest in the same 500 companies.
The Dow Jones Industrial Average is another “index” that tracks the activity of 30 “blue-chip” companies. It is important to note that both Dow Jones and S&P 500 are “averaging” indexes, e.g. they use the average stock value for their index. S&P’s 500 uses a “weighted” average which is believed to more accurately reflect the action of their stocks over a period of time.
Indexing is popular because, for instance, an investor in a mutual fund that tracks the S&P can feel secure knowing that the “best” stocks in the market comprise the portfolio of which he is a part owner. While most mutual funds are “managed”, there are those that are not managed because they so closely follow the S&P or DJ indexes. Many pension fund managers use these indexed stocks as it automatically creates diversity in the market.
One other factor, that is not of much importance at this time but could become more important in the future, is that historically the stock market has outperformed the inflation rate (as well as most other types of investments). Therefore, an indexed product should provide a “hedge” against inflation.
One of the problems with fixed annuities is that the insurance company makes the investments that will determine the annuity’s return. In effect, the insurer is telling its customer that he/she should “trust me to make the best investments on your behalf.” Remember that deferred annuities are annual products, and the interest rate used during any one period is the result of the insurance company’s declaring what interest rate it will use. Also, if the customer does not like the interest rate at the end of any year, there is a surrender charge that can be quite severe in the early years of the annuity. Therefore, the annuitant cannot decide that they can make more money just by following the S&P or Dow Jones, cash out their annuity and invest it otherwise – without paying a large penalty.
With an EIA, there is no “trust me” factor. The annuity is indexed and moves according to the fluctuations of the market. Some EIA’s have some restrictions by making their plans subject to changes in the participation rates or “caps” during the limited liquidity years.
Indexed annuities are different from indexed mutual funds in one primary and substantial reason. With a mutual fund, if the index should take a dive, the monetary risk is with the holder of mutual fund shares. With an indexed annuity, however, the insurance company is the one that is at risk, as the annuitant does not lose his/her principal. This is guaranteed by the assets of the insurance company (and in most states, backed by guarantee funds also).
In the early 1990’s, EIA’s were introduced to the securities market through national stock brokerage firms, independent broker-dealer firms and regional brokerage firms. The national stock brokerage firms have not been very successful in marketing the EIA’s, as they have traditionally marketed investments with a risk factor and they have not actively marketed products with limited risk. The sale of EIA’s by these firms is increasing but not significantly. The independent broker-dealers have embraced this product however, as they usually take more of a professional financial planning approach with their customers and they recognized early how the EIA could be an integral part of their client’s portfolio. They have produced a large portion of EIA sales.
This product was a natural to life insurance agents who are accustomed to selling fixed annuities and life insurance that provides for safety of principal and interest rate guarantees. At last they can offer an equity-indexed annuity that is an insurance product and they do not have to go through the licensing routine of a securities dealer (although a recent survey indicated that nearly 80% of those agents who have sold EIA’s, are registered representatives). They can now actually offer their customers an opportunity to participate in greater growth in their annuities without the risk of losing their principal. Agents, as can be expected, are the largest marketers of the EIA product.
Banks have been interested in the EIA and bank sales have grown consistently. Many feel that banks will become a major marketing source as bank customers are perceived as conservative in their investments, and are not comfortable with risk products. With the guarantee of no market risk, they should be perfect for bank annuity customers.
Most of the EIA’s marketed today are not considered as security products and actually fit a heretofore vacant area between fixed annuities (insurance products) and Variable Annuities (security product). The few EIA’s that are registered are structured differently than the annuity type of EIA. The registered EIA must be sold with a prospectus and the agent must hold a NASD Series 6 or 7 license. Some states may require that the agent also pass the Series 63 examination.
Without going into detail as to the appropriate government regulations that determine what is a security product as opposed to an insurance product, basically in order not to be classified as a security, it must meet the following conditions:
It should be noted that under government regulations as summarized in (2) above, the EIA does definitely qualify as an insurance product because it declares the interest rate in advance.
It would be fair to ask why some insurance companies have registered their EIA versions. Probably, their sales force is mostly registered representatives who are used to selling Variable Annuities and other securities. Also, a registered product allows the salespeople to emphasize the product’s investment aspects.
It should be recognized that the S.E.C. could at any time decide that the product is a security and the agents must be registered representatives. Even though the best legal minds in the business maintain that such a decision would be contrary to the law, it could be costly and useless to appeal any such decision. Companies are still relying on the legal opinions of their attorneys and are treating the EIA as an insurance-only product.
FAn Equity Indexed Annuity is a Retirement Savings product.
The following discussion of provisions features the uniqueness of the Equity Indexed Annuity and it certainly does not cover all of the variations that are available on the market today. This product, still in its infancy, has already undergone changes and will undoubtedly undergo more in the future. Certain features are basic to all of the plans, and will be discussed in some detail.
The most significant and principal difference between the EIA and other annuity products is simply that the interest credited to these accounts is based on a market index. The index used in most EIA products is based on the Standard & Poor’s 500 because:
The S&P 500 is a “market-value” index, i.e. each company’s value is determined by multiplying the number of shares outstanding times the stock price. It is a “weighted” index, which means that each company’s “influence” on its performance is directly proportional to its market value.
To calculate the yield that changes in the index’s value, the formula is like that used to determine the changes in value of mutual funds, i.e. the value of the index at the end of the period measured, less the value of the index at the beginning of the period – divided by the value of the index at the beginning of the period.
Example: If the value of the S&P were 1000 on Jan. 1, 1999 and 1200 on Dec. 31, 1999, the yield for 1999 would be 20%. (1200 less 1000 = 200) divided by 1000 = .20
2d example: if the value of the S&P dropped by 50 points, then (950 less 1000) divided by 1000 equals a minus .05 or negative 5 percent.
S&P 500 index is reported daily in the Wall Street Journal, USA Today and many other newspapers. The index is reported by the following:
There are a few indexed annuities that use other indexes, in particular foreign stocks. By doing so, the annuitant can participate in the returns of overseas securities.
The Dow Jones Industrial Average, the Dow Jones Transportation Average, and the Dow Jones Utility Average are considered as the leading indicators of the stock market movement. Therefore it should be no surprise to discover that some companies are using the Dow Jones Indexes for EIA’s instead of the S&P 500.
Which is the best? The Dow Jones Industrial Average (DJIA) is weighted by price, as opposed to market value of the S&P 500. This means that within the DJIA, the high-priced stocks carry more weight than those lower-priced stocks. Therefore, a 3 or 4 % change in the price of a $100 share will have more of an impact on the DJIA than the same change in the S&P 500.
Using the S&P 500 as an index, a change in the price of a stock is multiplied by the number of outstanding stock. Therefore, a change of 3 – 4% in the price of a stock with a small market value will have a much smaller impact than a comparable price of a stock with a large market value.
While other indexes may appear, the key point is that it is very necessary to keep the process simple. Since the S&P 500 and the DJIA are both well known and well regarded, and somewhat understood by the majority of potential customers, there is little chance that any other indexes will have much of an effect.
Most investors are familiar with indexed mutual funds, but that has little to do with indexing of equity indexed annuities. With mutual funds the fund itself purchases stock that comprise the index. With EIAs, there can be – and is – a variety of indexing methods. In today’s rapidly changing financial environment, there can be methods that are beneficial if the market goes up, or if it goes down, or if it stays the same, if it goes up and down over a short period of time, etc.
Some of the new products have new methods of indexing, but traditionally (if you can have a “tradition” for a 6-year old product) there are six variations and will be discussed in detail. These are point-to-point, high water mark (look back), annual reset, low water mark, multi-year reset and digital. The other features of the EIA, such as floors, caps, participation rates/margins, and averaging, may work together with the methods of indexing.
The simplest indexing method is the point-to-point method. The beginning “point” is the beginning date of the contract, i.e. the day that the premium deposit is made. The end “point” is the last day of the contract’s initial term. The difference in the index value between the two points is the amount of interest that will be credited to the annuity. For the mathematically minded, the formula is simply: The “Beginning Point” is subtracted from the “End Point”, and the result is divided by the Beginning Point.
CONSUMER APPLICATION
Ralph has a 5 year EIA with 100% participation and the S&P 500 index is at 1000. His Initial premium deposit would be $10,000. At the end of the initial term, the index stood at 1500. Therefore, subtracting 1000 from 1500 is 500. 500 divided by 1000 is .50 or 50%. The full 50% would be credited (100% participation) and the credited interest would be $5,000 (50% of $10,000).
If the market “went south”, the minimum rate would still be 3%. This is discussed later in this section. This would be true of any of the methods of indexing used.
Some have expressed concern that if the market should “soar to exhilarating heights” during the term of the annuity, but then falls off just before the end of the annuity, the annuitant doesn’t receive the benefits of the increases since only the beginning and ending points are used. The movement of the market during the annuity term does have an effect, though, as the last (end) point would almost certainly be higher if the trend during the annuity period was continual gains.
The Point-to-Point method of indexing is good in bullish markets, but is very dependent upon a single end point. A little bad timing at the end could wipe out the result of several upward years. Another criticisms leveled against this method is that at the end of the second year, or even later years, an annuitant has no way of knowing how much his/her annuity value will increase. This has been referred to as the lack of “instant gratification.” This is similar to the advice of financial “experts” in the stock market, whereby they tell investors, “Don’t look at your stock returns every single day.” Much easier said than done. It is human nature to want to know your financial standing at any particular time, or at least be able to approximate it.
Vesting, as discussed later, and an averaging technique, serves to alleviate these problems. For instance, vesting means that at the end of each year, a certain percentage of the account value will be “vested” and credited to the account, subject to participation rates and surrender charges.
FPoint-to-Point products work best in an upward or bullish market.
The “high-water mark” method is a popular indexing method, and is used heavily by one of the companies who “started” the modern equity indexed annuity. Many agents consider this method as the method that they would like in their “ideal” EIA.
As in the point-to-point system, this method uses two points in time: the beginning point is when the premium is deposited into the annuity. The other point is not an “end” point, but is a point during the annuity period when the index value was the highest. The mechanics are the same as the point-to-point method, except that the “high” points substitutes for the “end” point.
This method satisfies the “instant gratification” problem as the contract holder knows that the value has been locked in when they reach that point. Therefore, even if the market index declines, it will not have the same negative effect that the point-to-point method has.
It will be noted in this discussion, that on occasion, certain provisions of an EIA will be more conservative in order to allow more liberal provisions elsewhere in the contract. This is one of those situations. A product using the High Water Mark method normally has a lower participation rate. The reason is that the cost to the insurer in investing to compensate for this feature is much higher than in other products.
FThe High-Water Mark method performs best in a market that peaks early during the contract period, and then declines for the rest of the contract period.
This is also a method that appears on agent’s “wish lists” as it can be very powerful if the market is right. Simply put, instead of the index covering the annuity period as a single entity, it allows the experience of each year to stand on its own. If it were a 7- year annuity, there would be a new calculation at the end of each year. In effect, it measures the changes in the index with a series of beginning & ending points. Today (2003) this is most popular indexing method.
Mathematically, the formula is the same as the point-to-point, but it is performed at the end of each year. If the “end point” minus the “beginning point” is negative at any year, then the index is zero for that year.
This type of method suits the equity-indexed annuity perfectly in a lot of ways. If the market goes up, the annuitant participates through the index method. However, if the market drops, the annuity will show a zero interest contribution for that year. (This is where the “floor” comes in, which is usually “zero” in most contracts). However, and it is a big “however”, the next year the annuitant can start over. Historically, the stock market usually performs the best after it has reached a substantial low. Talk about timing!! The annuitant participates in the “good” years and “just goes along for the ride” during the “bad” years.
As good as this product is, there are still a couple of drawbacks. Nothing is perfect. One factor is that it is confusing to the ordinary investor, inasmuch as the contract extends over several years but the method operates on an annual basis.
The annual reset design is expensive for the insurer. Since the formulas differ each year, not only the investment costs are high, but also so are the administrative costs. Therefore (trade-off time again) this method usually has the lowest participation rates of any EIA plans.
Perhaps the greatest handicap of the annual reset method is that the interest credited to the account each year is compounded. Certainly the compounding of interest into the product design would appeal to clients. However, since this method is very expensive for insurers, some insurers do not include a compounding feature. Some companies do allow compounding but include a “cap” (described later) which limits the amount of interest credited in any inter-crediting period.
FAnnual reset annuities work best in a market that is highly volatile over the contract term, and performs the worst if the market is steadily rising and has low volatility.
Forget the “low” terminology as this method can produce good yields. Under this method the “end point” is the last day of the contract term. The beginning point is the contract anniversary date when the index reached its lowest value. The mathematical formula would be “Earning Point minus the Lowest Point, divided by the Lowest Point.”
The thing that should be emphasized is that the lower the starting point, the higher the index will become. This method works well in many different environments, however:
FThe Low-Water Mark method works best in a market that takes a deep dive in the early part of the contract term, then rises throughout the rest of the contract term. It will not do well if the market declines early and does not recover during the contract term
This is another method renowned for its simplicity. This method credits a particular rate of return every year that the index is positive; and credits another particular rate of return every year that the index is negative (usually zero). As an example, if the particular rate of return is 15% and zero (-0-) when the index is negative, either one or the other, hence the “on and off” connotation. Generally the rate of return for years when the index is positive will continue throughout the policy duration and will not change for the policy duration.
The index is evaluated each year. In comparison to the annual reset method, if there is an upswing in the index performance after a downswing, the annual reset method allows for a substantial increase in the interest credited to the contract for that year. However, if the contract uses the digital method, then the “upswing” would be restricted to whatever the contract states.
The “trade-off” for the digital method pertains to the interest compounding. Contracts using the digital method may allow for compounding or not, but those that allow for compounding may have a lower rate of interest than those that do not allow compounding.
FThe Digital Method works best in a modestly rising market, and works worst if the market is alternating large upswings with downturns – especially if the downturns are small.
The Multi-year Reset method operates much like the Annual Reset method, except that the rate is based on the result of more-than-one year (takes a larger “bite”). For instance, if the contract term were 10 years, the Multi-year Reset Method would be calculated every two years (or more – in any event it is always less than the contract duration). At the end of each period, a new beginning reset period is determined and another multi-year period will start.
The formula is the typical Ending Period minus the Beginning Period value, divided by the Beginning Period Value. However for the life of the contract, it would apply at the end of each term. Using the 2-year example, that would mean that it would be “reset” every two-years.
If the index performance is positive during any multi-year period, the participation rate is applied to determine interest earnings for the contract. Conversely, if the performance of the index is negative during any multi-year period, no interest is credited to the contract, but also, no interest is lost.
If the contract allows compounding of the interest, the results of each multi-year period are multiplied together to determine the total amount of the end-of-term interest. If the contract allows for simple interest, then the results of each multi-year period is added together.
FMulti-year reset contracts works well in a rather modestly capricious market, particularly if the upsurges and the downswing parallel the contract’s reset points. It performs worst in a market that is rising steadily and smoothly.
Some persons believe that “averaging” is a method of calculating indexed returns. Not true. Averaging is incorporated into many indexing methods however. Averaging is used so that the experience of a single day cannot be used as the starting point or ending point in indexing. In April 2000, the markets all took huge losses, including the S&P 500. What if a contract just happened to have an end-date on the day of the crash!
Averaging is accomplished by taking the closing index prices over a pre-determined number of days, adds them together and then multiplying by the number of days. It can be performed the same way by using months or quarters, but usually it is days.
An averaged point can be either the end point or the beginning point, but usually it is the end point, and is usually averaged during the last year of a point-to-point contract.
Averaging accomplishes what shock absorbers do to the ride of a car – it levels out the bumps and holes. Years when the stock market rises during a year, and then declines toward the end of the year, the averaging will produce excellent results. However, if the stock prices rise steadily during the year, the return will be halved.
For the mathematically inclined: if the contract has a 7-year term, and averaging is used during the last year, the last year’s average would be: 1st Quarter+2d Quarter+3rd Quarter+4th Quarter, the total divided by 4. Just like in the 4th grade.
STUDY QUESTIONS
1. The Equity Indexed Annuity (EIA) is not a (an)__________ and should never be directly compared to a ____________.
A. annuity – annuity
B. security – security
C. insurance plan-annuity
D. annuity - security
2. Simply put, an EIA is
A. an immediate Variable Annuity.
B. an adjustable Variable Annuity.
C. a fixed deferred annuity.
D. a fixed premium Variable immediate annuity.
3. One of the big advantages to a purchaser of an EIA over a fixed annuity is that
A. he knows that his funds are all invested with the other funds of the insurance company.
B. the annuity is indexed and moves in accordance with fluctuations in the market.
C. the fixed annuity principal is not guaranteed.
D. the annuity funds are all held separately as with Variable Annuities.
4. In order for the EIA product to remain an insurance product,
A. the product must be issued by an insurance company.
B. the investment risk must be assumed by the purchaser/investor.
C. it must be marketed as a security.
D. the funds must be guaranteed by the Federal Government.
5. The index used by most EIA’s is
A. the Russell index.
B. Dow Jones Industrial Average.
C. Standard & Poor's 500.
D. Merrill Lynch Averages.
6. Point-to-point products work best in
A. an upward or bullish market.
B. in a market that huge downward swings.
C. a declining market.
D. a wildly fluctuating market with huge increases in value.
7. An indexing method that uses the beginning point and a point when the index was the highest, is called
A. The High Water Mark method.
B. The Annual Reset method.
C. The Low Water Mark method.
D. The Multi-Year Reset indexing Method.
8. When an index covering the annuity period allows the experience of each year to stand on its own, is called
A. the Multi-Year Reset Indexing Method.
B. the Annual Reset Method.
C. the Digital Indexing Method.
D. the Low-Water Mark Indexing Method
9. When the formula of “earning point minus the lowest point, divided by the lowest point” is used, the method is the
A. Digital Indexing Method.
B. End point indexing method.
C. Annual Reset Indexing Method.
D. Multi-Year Reset Indexing Method.
10. This indexing method credits a particular rate of return every year that the index is positive, and credits another particular rate of return every year that the return is negative. It is the
A. Annual Reset Method.
B. End-Point Method.
C. Digital Method.
D. High Water Mark Method.
1B 2C 3B 4A 5C 6A 7A 8B 9B 10C