CHAPTER SEVEN – FUNCTIONS AND USES OF EIA’S

 

 

HOW ABOUT DIVIDENDS?

 

The S&P 500 and nearly all other listed indexes are called “price” indexes, meaning that they reflect only the price of the stocks in the indexes and do not reflect any dividends or reinvesting of dividends.  Therefore, EIA’s that use the S&P 500 index will not reflect dividends.  At one time dividends accounted for 2 to 4 % of the stocks annual returns, but it dropped to a little over 1% of the total return after about 1995.  Therefore, since dividend yields are lower than they had been before, it would indicate that they will not have any long-term impact on the market performance.

 

It should be fully understood by the marketer and by the consumer, that buying an EIA that is linked to the S&P 500 is not the same as purchasing stocks in the S&P 500.  This does not mean that the EIA is an “inferior product,” but is just one of the items that the purchaser of an EIA gives up as a trade-off to eliminate the market risk.

 

Since there is a separate S&P index that does reflect dividends, there are a handful of EIA products that have been designed to include dividends.  As will be emphasized in this text, there are only 100 pennies in a dollar, so there will be a trade-off by the EIA having a lower participation rate as explained later.

 

GUARANTEED RATE – THE SAFETY CUSHION

 

All EIA’s have a guaranteed minimum interest rate, usually 3%.  Why so low?  Insurance products are subject to “non-forfeiture” laws, which specify the minimum interest rate that must be attributed to a policyholder upon the “forfeiture” of the policy, usually annuitization or surrender.  The non-forfeiture provision is a function of state regulations and there may be some differences, however 3% is considered as the “standard.”  Fixed annuities normally apply the guaranteed minimum interest rate to the entire premium deposit each year.  If the insurer declares a higher interest rate, then that rate would apply, but in no circumstances would it be more than 3%.

 

At the end of the contract’s term, the contract holder will receive the greater of:  (1) the guaranteed minimum value of the contract, or (2) the indexed value.

 

HOW LONG WILL THE CONTRACT RUN?

 

The term that is used to define the time length of an EIA is the “Initial Accumulation Term.”  This can vary anywhere from one year to 15 years, but the usual period is 5 to 7 years.  The initial accumulation term has two functions:

(1)  the length of time that the indexed rate of return is applied to the contract, and

(2)  the length of the surrender period during which surrender charges apply.

 

At the end of the contract period, there is a “window” of (usually) 30 to 45 days for the annuitant to determine if they want to annuitize (cash-out) the annuity, full or partial withdrawal of the funds, or renew the contract for another term.  If no choice is made, some companies will automatically transfer the funds into a fixed annuity.  Others may simply renew the contract for another term.

 

HOW MUCH IS SUBJECT TO INTEREST PARTICIPATION

 

First, it should be pointed out that premiums for EIA’s are in most cases, single premiums, with typical minimum payment of $5,000 or more.  However, some companies are allowing additional premium payments, usually in amounts of $50 to $500.  This is important to know as customers may question as to why, since they have made a large payment, they are initially only going to receive credit for part of the amount.  Secondly, participation rates may differ according to the date that a payment is made.

 

Another rather unique design of the EIA is the “Participation” rate.  This is simply the percentage of the premium deposit and annuity value that will be applied (credited) to the contract.  “Participation” comes from the fact that it determines what percent the contract “participates” in the contract’s indexed return. 

 

In order to determine the actual interest rate applied to the contract, the first step is to determine the yield of the index used.  Then the participation rate (percent) is multiplied by the participation rate to determine the amount of interest to be credited.

 

 

Participation rates can range from 20% to over 100%.  One company uses 100% of the average of the daily closing prices during the year.  The participation rate depends upon the features of the product, i.e. generally if the participation rate is low, the contract has more liberal features in other areas.  Of course it also depends upon the insurer’s internal indexes and cost allocations.

 

A higher participation rate does not necessarily mean that it will result in higher interest crediting, as will be explained later.  Also, most EIA contracts will use the same participation rate throughout the contract term, but some contracts will change participation rates annually.

 

The fact that the EIA collects its premium usually in a rather large lump sum, but the entire amount immediately “reduces” in value (in most plans) can cause questions in the minds of the customer (and the marketer, the first time they see this).  One of the reasons is that most insurance regulations allow an insurer to collect a 10% “load” on an annuity for administrative purposes.  While this is factual, it is of little interest to the consumer.

 

There are two reasons that can be explained to the customer:

 

1. At the guaranteed rate of 3%, for instance, a $10,000 premium deposit will start exceeding $10,000 in value after about 3 ½ years.  If the “math” is done, over $11,000 will be credited to the account after 7 years.

 

1. And most importantly, this product should not be sold to anyone that will have immediate liquidity needs, or needed on an on-going basis, or will need to surrender the contract prior to the contract term.  It cannot be emphasized enough:

 

 

An “alternative” to the participation rate is the “Margin” (also known as the ”spread”) used on some contracts.  The “margin” is subtracted from the indexed yield (instead of being multiplied as with the participation rate).  For instance, the margin rate on a contract may be 5%.  If the indexed yield is 10%, then the interest rate credited to the EIA would be 5% (.10 - .05).

 

The question as to, which is best for the client, frequently arises when discussing margins and participation rates.  Mathematically, different assumptions will produce different results because the two are not mathematically comparable.  Basically, when indexed rates are low, then the participation rates may produce better results, and conversely, when the indexed rates are high, the margin may produce better results.  There may be more technical answers but simply put, “it just all depends”, as one is not comparing apples-to-apples.

 

Margins may be used for any EIA product, but are most commonly used with annual reset products.

 

CAPS – IS THE SKY THE LIMIT?

 

Some – not all – EIA’s have a “CAP” or limit on the amount of indexed interest that can be applied to the contract during a certain period, regardless of how high the indexes may go.  As an example, a contract may have a cap of 12%.  If the market-oriented index soars to 15% in one year, the maximum that will be attributed that year, would be 12%.

 

How is this explained?  The actual and true reason for the cap is that it protects the insurer against “wild fluctuations” or very substantial index increases.  Therefore the insurer is able to offer other attractive features, without which they would not be able to do so.

 

One large broker who sells a substantial amount of EIA’s, and whose remarks have been seconded by many other marketers, in a recent survey by Life Insurance Selling”, stated, in effect that his chief concern for both buyers and sellers of EIA’s, is the cap on returns.  “Inferior products” (his terminology) that cap returns have cost annuitants millions in lost gains.  This is particularly noticeable during 1998 for instance, when the indexed rates would have almost always created returns in excess of 20%.  An annuitant at that time would have been losing 6%.

 

Caps may be applied to any indexing method but they are generally found on annual reset contracts. 

 

WHAT IF THE INDEX NOSEDIVES?  – THE FLOOR

 

The floor is the minimum amount of indexed interest that will be credited to a contract in any one year or over several years and applies only to those contracts that determine index interest annually or multi-year.  In most contracts, this amount is –0- (zero), which means that if the index drops, there will be no interest credited.  But this doesn’t mean that the customer’s account value will lose, it will just remain the same as the previous year.

 

Example:  Participation percentage is 80%.  The first year the indexed percentage is 10%, therefore 8% is credited.  Second year the index drops to 5%, 4% is credited.  The next year the bottom drops out and the index drops to a minus 15%.  In that case –0- would be credited.  The fourth year however, if the index yield increases back up to 5%, 4% would be credited for that year.

 

The Floor and the guaranteed minimum interest rate are two different things.  The guaranteed minimum interest rate is what the contract owner will receive at the end of the contract term if the accumulations of the indexed amount are less than the minimum interest rate.  The floor is the lowest amount that can be credited to the indexed interest in any particular year or years.

 

EARLY OUT – VESTING AND SURRENDER

 

There are two provisions that address early withdrawal of funds, either partially or totally. 

 

“Vesting” allows for partial withdrawals or surrenders and operates much like a pension fund’s “vesting.”  A percent each year of the account value at the end of each year is available from the total contract’s value.  For instance, many EIA’s that have this feature allow for an increasing percentage of the cumulative interest credited.  If the contract term is 5 years, for example, the percentages may start at 20% the first year, and increase by 20% increments until 100% of the amount is vested in the 5th year. 

 

The purpose of this feature is to protect the insurer from early contract surrenders.  An insurance company invests in financial markets that closely approximate the EIA’s that it markets.  If a number of EIA’s terminate early, this means that the insurer will have to cash-in some of its investments to meet the demand for cash because of contract surrenders.  An early termination of investments always is expensive as most financial products have some sort of protection against early termination, or it could occur when the market was down, resulting in the sale of investments at a substantial loss.

 

Mathematically, the beginning year account value is increased by the interest that is credited to the contract.  The vesting percentage is applied to that amount to determine the amount vested. 

 

Surrender charges of EIA’s differ from surrender charges of other fixed annuities.  Usually if there is a vesting provision, there are no surrender charges.  Otherwise, they have a schedule that declines over the number of years the contract is held. 

 

Early surrender of an EIA can mean that the annuitant loses not only the surrender charge, but can lose the interest credited to the account that year.  For instance, if the policy anniversary date is June 1, and the contract is surrendered May 1, the amount that is tendered may be based on the previous year’s account value.  If there had been a substantial increase in the index for the 11 months prior to surrender, this could mean more of a loss than anticipated.

 

THE END PRODUCT - ANNUITIZATION

 

The principal purpose of an annuity is to guarantee an income stream after retirement to supplement other retirement income, such as Social Security, pension plans and other investments.  Through the accumulation of funds, the annuitization of an EIA operates just like any other annuity.  The insurance company assumes an interest rate that considers the annuitant’s age, sex and anticipated longevity and whether it is a single or joint annuity.

 

Once the values are annuitized, the amount of the monthly (or other mode) payments will remain the same.  Some insurance companies are attempting to create a product that will index the annuity payments and it is anticipated that both immediate and deferred annuities will offer this feature.

 

The comparison of risk of various planning and investment products can be illustrated by the following:

 

RELATIONSHIP OF RETURN AND RISK

                                                                                                                                    (High)

 

                                                                                                                        Commodities

                                                                                                                           Options

R                                                                                                         Limited Partnerships

                                                                                         Individual Stocks

E                                                                             Corporate Bonds

                                                                        Mutual Funds

T                                                              Money Market Funds

                                                            Variable Life Insurance

U                                                         Variable Annuities

                       Equity Indexed Annuities

                                    Savings Bonds

R                            Savings Accounts

                            Life insurance

N                  Fixed Annuities-(fixed rate)

                  Government Bonds

                Certificates of Deposits

              Checking Accounts

       (Low)

R I S K

 

 

The top of this illustration shows those investments normally considered to be “High Risk.”  The bottom shows those which are normally considered to be “Low to No Risk.”  Following the point made earlier in this text, this illustrates again that the higher the return, the higher the risk.  The top 3 (Commodities, Options and Limited Partnerships) are considered High Risk, the next lower 6 investments are considered as Medium risks and the bottom 7 are considered as Low to No Risk.  An attempt is made to “rank” them in order as to the risk, but some may differ as to the order.  For instance, while a Certificate of Deposit is guaranteed by the FDIC for up to $100,000, a CD for $250,000 would not be as “safe.”  In respect to Government Bonds, this refers to all “governments” that issue bonds, and on occasion a municipality has had to default on its bonds.  So whether a products guaranteed by a “government” is safer than that guaranteed by an insurance company, may be argued any way. 

 

The idea of this illustration is to show that the EIA as an investment is a secure investment, but even though it is first and foremost, a Fixed Annuity, with all the safety thereto, it can be legitimately shown as higher in return and lower in risk than almost any other product.  The EIA “breaks the mold” in investment products, as shown in this illustration, and that, of course, is the attractiveness of the product.

 

COMPARISONS WITH OTHER ANNUITIES OR MUTUAL FUNDS

 

ANNUITIES

While there are certain limiting factors with the EIA, the prospect of participating in the gains of the S&P 500 or other indices, without suffering the losses inherent in the market, is quite appealing. 

 

How the growth is determined:

1. With the Fixed-rate Annuity (FRA), the rate is set by the contract.
2. With the Variable Annuity (VA) the contract holder (or investor, if you will) may select one or more Mutual Funds.
3. The EIA increases are tied to the S&P 500, Dow-Jones, or other indices.

 

Is the rate guaranteed:

1. The rate is guaranteed by the FRA, but not with the VA or the EIA.

 

Is there a minimum guarantee:

1. FRA has a minimum guarantee, as does the EIA.  The VA does not.

 

Is there a loss potential:

1. While there is no potential loss for the FRA or the EIA, there is for the VA.

 

Is there, then, the potential for gain:

1. The FRA has only a slight (or modest) potential for gain, while with the EIA it is very good.  Of course, this is the “meat” of the VA, so the potential for gain is excellent.

 

How about access to the money:

1. With the FRA and the VA, access is quite good, but with an EIA, depending upon the contract, it is somewhere between nearly impossible, to quite good also.

 

MUTUAL FUNDS

 

At least half, if not more, of investors in the U.S. are investing or have invested in Mutual Funds.  This gives them an advantage over the EIA as the EIA is a relatively new product and only a small fraction of those who invest in Mutual Funds have even heard of the EIA.  All mutual funds are either “Equity Funds” (SF), i.e. invest in stocks, or “Debt Instrument (Bond) Funds” (BF) which invest in bonds and money market instruments. 

 

Using the criteria as above, the following comparisons can be made.

 

How the growth is determined:

1. With the SF, growth is based on the stocks in the portfolio.  With the BF, of course, the growth is determined by the growth of the bonds in the portfolio.  The EIA is tied to the increases in the S&P 500 (or other indices).

 

Is the rate guaranteed:

1. The rate is not guaranteed by the SF, BF of the EIA.

 

Is there a minimum guarantee:

1. There is no minimum guarantee by the SF or BF, but this is the strong point of the EIA.

 

Is there a loss potential:

1. Conversely, there is a potential for losses with either the SF or the BF, but not with the EIA.

 

Is there, then, the potential for gain:

1. The SF has the greatest potential for gain of the three, with BF usually having a modest potential for gain.  The potential for gain with the EIA is excellent (not as good as the SF, but not bad either).

 

How about access to the money:

1. An advantage with Mutual Funds, Stocks or Bond funds, is that there is relatively easy access to the money.  Again, depending upon the EIA, access is either poor to quite good.

 

Equity (stock) mutual funds very frequently do not perform as well as the S&P 500.  According to a study by Lipper Analytical Services, the percentage of equity mutual funds that have done worse than the S&P 500 are shown in the following graph.

 

 

Percent of stocks doing worse

than S&P 500

 

WHAT HAPPENS NOW?

 

After a blazing four years of great returns in the EIA, the brakes were starting to be applied in 2000.  The problem is that with the volatility of the market, fixed equity products are bringing in returns that swing from one end of the spectrum to the other.  A good agent that can offer any protection against the swings of the market will be valuable.  In many cases this will be the difference between keeping and losing a customer.

 

Throughout the short life of the product, the EIA’s have had many design changes and features have been added.  But regardless, nearly all – about 85-90% - EIA’s share one important feature.

Despite all of these changes, one key element of most EIA’s available, is the annual reset and lock-in methodology.

 

Some of the changes have been in the use of “Caps”, the advent of the index/margin fees, and the differing kinds of averaging.  As stated elsewhere in this discussion, very recently there have been swings away from the Standard & Poor’s 500, and some use the Dow Jones Industrial Average, the Russell 2000, the NASDAQ 100 and/or different bond indexing.  Recently some EIA’s offer the customer a choice, and in some cases, asset re-balancing. 

 

To reiterate – every EIA has an indexed starting point (issue date usually) and is the number from which all gains or losses are measured, as compared to the index value at the end of the

 

indexing term.  This is the “foundation” from which the interest is credited to the policy, after the participating rate, crediting method, margin, and/or the “cap” of the policy are applied.  The annual reset feature as the term would indicate, in fact “resets” the index starting point on each policy anniversary and the ending index value is the index new starting point for the next index term, as explained previously. 

 

The gains realized on the policy during the reset period are “locked-in” and is added to the accumulation value.  The beauty of this, when applied properly, is that the gains already realized, cannot be lost, regardless of how the market fluctuates.  The importance of this can best be understood by the following “Consumer Application.”

 

 

This “Consumer Application” is simplistic perhaps, and may (or may not) reflect “real life”, but regardless, it cannot be ignored.  If the professional agent does not point out to the customer what can arise in a situation such as this, it would be a good bet that another agent would be doing so.  Besides, the average length of the term of an EIA is 7 to 10 years; this can be a long time to wait for results.

 

At the very least, an agent would want to have an EIA with the annual reset and lock-in feature in his/her portfolio.

 

WHAT’S OUT THERE?  SUMMARY OF PRESENT PRODUCTS

 

The following summary of EIA products is a 1999 survey.  EIA products change rapidly, which is typical of any new product of this type.  The following summary will at least give a starting point in understanding the plans available.

 

Types of Premiums

            Single Premium                                                           68%

            Flexible Premium                                                        32%

 

Methods of Indexing

            Annual Reset                                                              50%

            Point-to-point                                                              33%

            High Water Mark                                                        16%

            Others                                                                                       1%

 

Features as Gauged By Use In Current Products

            Participation Rate                                                       65%

            Margin only                                                                   7%

            Margin and Participation Rate                                      3%

            Cap with Participation Rate                                        25%

            Participation &/or Margins that can change                33%

            Averaging                                                                   60%

            Vesting                                                                        20%

            Specified Surrender Charges                                      85%

            Surrender Charges not specified                                 15%

 

Interest Calculation

            Compound                                                                  85%

            Simple                                                                         10%

            Not applicable                                                               5%

 

If Free Withdrawal privileges are available, more than half use a percentage of the indexed value; about 15% use a percentage of premium; around 15% have no privilege for withdrawal and the remainder have some other sort of calculation.

 

RECENT  MARKETING COMMENTS ON EIAS

 

Several publications, including Life Insurance Selling, early in 2001 have articles about the EIAs from the viewpoint of those who have had success in marketing this relatively new product.  These comments are abbreviated and are presented here for the unquestionable value of the viewpoint from those who know the product(s) well and have been successful in marketing EIAs to the general public. 

 

Prime Candidates for EIAs are those who may have 401(k) plans, pensions, or IRA rollovers and they wish to reinvest their money without risk.  Many clients take required minimum distributions (RMD)from their IRA at age 70 ½.  When compared to equities, the EIA takes the guesswork out of trying to determine the best time to liquidate shares for the RMD.  With the EIA, gains are credited and become a guaranteed part of the contract, and then most companies automatically send out the RMD.

 

As interest rates continue to decrease in the early part of 2001, many predict that more and more producers will seek alternatives to the traditional fixed annuities and CDs.  Clients are not going to be motivated to tie up their money for several years at a 6% (or below) interest rate.  These EIAs will at least give them a good chance for returns that are higher than the traditional annuities.

 

Now that the interest rates have begun to decline, EIA’s appeal is increasing once again.  From the S&P 500 results, it has been noted that 2000 was the first year to show negative figures in the market since 1994 and the first double-digit loss since 1977.  In the past 25 years, there have been a total of five negative years of growth.

 

Because so many people buy when the market is high and do not buy when the market is low, many people have been “burned” by these fluctuations.  EIAs eliminate the risk of being “burned.”  Most newer EIAs are annual reset/annual lock-in designs, which eliminates the “bad time to buy” obstacle.  Therefore, many large producers are confident that EIAs will affect annuity sales significantly next year and in the next few years.

 

In the area of advice to new producers, it has been pointed out that often producers describe in minute detail how the crediting methodology works.  However, they spend very little time defining what the client’s general expectations should be.  Just having the client understand how the crediting method works, does not guarantee that his expectations are reasonable.  As one General Agent put it: “Many producers get so tied up in describing how the watch is built, that they forget to tell the client what time it is.”

 

Many companies are now offering more than one market index, and one company in particulars now offers a choice of 5 different index accounts:  Dow-Jones Industrial Average (DJIA), NASDAQ 100, the Russell 2000, the S&P Midcap 400, and the S&P 500.

 

 

Nearly all producers questioned or who have written about EIAs firmly believe that the market being sub-par in 2000, can be a good thing for EIAs.  Many investors had year after year of outstanding returns, and suddenly they realize that, yes, the market can go down also.  Many investors are, or will be, looking for EIAs to capture some of the substantial market gain that they have achieved over the past few years and protect them from any future market downturn.

 

The slowing economy has affected EIAs in several ways.  First, as interest rates decrease, participation rates seem to shrink because of smaller option budgets.  Second, some consumers choose to sit on the sidelines during the times of economic unrest.  The reality is that now is the best time to purchase EIAs as many people would benefit from lower starting points for their indexing calculations.  Several of the large producers emphasized that this is a good time because of the indexing starting point.

 

There is one “downside” noted by some.  The EIA market seems to be in a “holding pattern”, i.e. many brokers have seen margins increase, or caps and participation rates decrease, in as early as the second year of the product’s life.  This type of activity has angered clients, which then causes brokers not to offer the product at all.  Some feel that this activity will not change because more carriers are offering products with fewer guarantees in an effort to become competitive in the first year.  And of course, as stated frequently in this text, this product is not, and was never intended to be or designed for, a one-year product.  Those producers who have noted this “downside” are articulate in demanding a simplification of product.

 

Increased volatility in the market has had an effect on the kind of EIA products that are popular.  For example, market volatility plays to the strength of the EIAs that use an annual reset crediting method.  Continued volatility also may add to the popularity of flexible premium EIA products as dollar-cost averaging vehicles.  If the volatility persists, say some, it may swell EIA sales as Variable Annuity policyholders whose surrender periods have run out, are attracted by the EIAs guaranteed minimum interest rates and security of principal.

 

Companies are taking a long hard look at their agents, and at least one company now requires that all of their agents marketing EIA products be “certified” which is offered by the company and which educates the agent not only in EIAs, but also about the business as a whole. 

NOW THAT WE KNOW WHAT THEY ARE, HOW ARE THEY USED?

 

Remember that an EIA is a form of deferred annuity and therefore it is used as a deferred annuity, i.e., it is generally used for long-term investments and for long–term accumulation of funds.  Therefore, retirement is an example of what the annuity was designed to do.  Funds accumulate on a tax-deferred basis, which is probably one of the most used feature that is sold in recommending annuities for financial planning.

 

Further, an annuity has many options available when the annuity is “annuitized.”  If the life income option is chosen, the income cannot be outlived – guaranteed. 

 

The Equity Indexed Annuity has some further features that recommend it for financial planning.  Because the EIA is an (attractive) alternate to other, much riskier, investments, it provides an opportunity to “beat” the rate of inflation and to do so without market risk, while offering a potential for higher market returns.  As most investors know, or are made aware of, over a period of time, investments in equities out-performs the rate of inflation, and have done so better than fixed-interest investments such as Treasury bills and Bonds. 

 

Until the EIA was introduced, if an investor wanted to offset the effects of inflation on their personal retirement savings, there was no vehicle or easy way to do so.  Some investors refused to take the market risk at all, and invested only in guaranteed products.  Even though there is no guarantee as to how the market will perform in the future (or even in the next 15 minutes!), the EIA offers the customer the potential to receive a rate of return that is higher than the rate of inflation.  A survey of mutual fund investors showed that 27 percent of investors in mutual funds were very cautious about taking any risk and would avoid any investments that might be construed as “risky” in any sense. 

 

Some investors, super cautious, believe that they will be better off with their Certificates of Deposits (CDs).  Maybe, but probably not.  The Federal Deposit Insurance Corp. (FDIC) insures any bank CD balances of $100,000.  Investors have actually experienced losses where they had CDs for amounts exceeding $100,000.  Conversely, losses on annuities have only had one loss, and those annuitants did not lose their principal, only the expected return for one year.

 

In addition, annuities almost always carry higher interest earning rates than CDs, and – this is of utmost importance – because their earnings are tax deferred, they actually earn even more because with good planning, their marginal tax rate will be less when they annuitize (so they pay less taxes) than during the accumulation period.

 

One note of caution when EIA’s are used for an IRA.  The contract period must coincide with or be earlier than, the date that the annuitant turns age 70 ½, or severe tax penalties will occur.  This pertains to any IRA, regardless of the type of funding.

 

When discussing an EIA with a customer, as indicated earlier in this text but should be repeated again for emphasis, an EIA should never be directly compared to a registered security.  (In those instances where the EIA is a registered product, then this would not apply).  Any attempt to promote the EIA as a “superior” product can have negative implications.  Presenting a nonregistered EIA as if it were a security is a violation of the Securities laws.  However, as good as this sounds and as accurate as the statement is, there will be times when a potential customer who is familiar with mutual funds &/or other investments, will demand some sort of comparison.  Not to provide a comparison under these circumstances could make it appear that the agent is “hiding something”, or he/she is simply not well versed in the product. 

 

How to handle, how to handle??  It is recommended by those with experience in this product, and by companies who are very sensitive to the dividing line between insurance and securities, that:

 

 

To reiterate: A registered security product participates fully in both market gains and market losses.  The amount of the investment (principal) is not guaranteed and they can be purchased for either short-term or long-term investing.  EIAs, however, are purchased by consumers primarily for the purpose of accumulating savings for their retirement

 

A good way to understand how an EIA may be used (there must be thousands of specific instances) can be summed up in the following Consumer Application:

 

 

Please refer to the last chapter of this text (Pot-pourri) for a discussion of “Split Annuities” which can accomplish similar goals, using only annuities.  The Consumer Application shown above is a practical approach as if a client who has to work for their money has a $1 million in mutual funds, they evidently have some confidence in them and they would in all likelihood protest if all of the funds were to move immediately to another investment vehicle with which they are unfamiliar. 

 

WHAT DO THE AGENTS THINK ABOUT EIAs?

 

Various insurance industry publications, as well as releases from insurance companies and brokers that specialize in EIAs, have discussed the EIA from the marketing viewpoint.  Many of those that have written articles or contributed to surveys, etc., are professional financial planners so their opinions are well worth reviewing. 

 

THE MARKET

 

Generally, the EIA is recommended to those who want to improve their return on investments, compared with a CD, for example.  Some people have done well with other investments and now want to save their gains for retirement and still “participate” in the market without the attending risk of other investments.  Other interested parties are bondholders, charities with money in other “safe” investments and those with under-performing annuities, or those with no surrender charges on their annuities.

 

One financial planner states, “The only situation in which I do not recommend the EIA is when they are looking for a fixed income.”  The usual purchaser is over 50 and has over $100,000 to invest.  One common characteristic of EIA prospects appears to be those persons who have identified a part (or all) of their investment portfolio that they do not want to expose their investments to risk, but still wants an alternative to fixed interest investments.

 

Many financial planners maintain that “almost everyone” is a potential EIA customer.  There is a new category of “super-wealthy” individuals who do not want to lose their money, but still wants to participate in the market.  In other words, those who believe in long-term gain potential but still want to lock in past gains.  Those people, who have identified “safe money” as part of their savings plan, are “naturals” for EIA’s.

 

Perhaps because so many financial planners are registered representatives, several professionals have stated that the EIA should not be presented as an alternative to investing in the market itself.  They stress that the EIA is “different money” - it fills different needs, and is in a classification all of its own or risk-based products and solutions.  The consumer, who is uncomfortable with money invested directly in the stock market and in Variable Annuities and mutual funds, may be very interested in an EIA. 

 

In some fashion or other, many financial planners classify their clients who can benefit from an EIA, into one of the following categories:

 

1. Those with money or designated savings or insurance plans that they want to protect with products that are conservative and use guarantees for both the downside and the upside fluctuations.

 

1. Those that have money gained from the stock market over the past 10-12 years, but are nervous about the long term and want to move some of their money into guaranteed products.

 

1. Investors who don’t think that the present bull market will continue and want to move their 401(k) or 403(b) accounts into EIAs.

 

1. Baby-boomers, who have 20 years or more to save for retirement, but want to diversify their plan with a guaranteed alternative.  They may not have much faith that there will be a Social Security “floor” for their retirement income.

 

THE DREAM PRODUCT

 

Of course, those who contribute to industry publications will strongly recommend whatever their particular organization represents.  This is natural, especially since this is a relatively new product and changes are occurring “even as we speak.”  As, for example, when the Universal Life policy was first introduced, producers made untold recommendations and actuaries worked overtime in order to “improve” the product.  It appears that this may be happening to the EIA product also. 

 

A comment from a producer that was one of the first to market EIA’s, and market it for one of the first company’s to offer this product, realizes that today, many customers prefer an annual ratchet type with an averaging feature and a 10% penalty-free withdrawal to allow for some liquidity.  Some are still satisfied with the “old” original point-to-point, S&P 500 indexed, with the income added each year on the anniversary date.  These producers feel that this is the simplest to explain to their customers and “if it ain’t broken, don’t fix it.”

 

One company’s best seller is an annual reset product, with a 10 year guaranteed 125% participation rate and a 5-year guaranteed 15% annual cap.  They have just introduced a new version that uses a flexible-premium with annual reset and with a 100% participation rate.  (Remember the discussion on giving up one feature in order to get another?)

 

The cap on returns has not been well received by the producers.  Because of the volatility of the stock market in today’s financial climate, many producers are concerned about tying the EIA only to the S&P 500 index.  They believe that if the S&P 500 drops for a meaningful (in the eyes of the consumers) period of time, that will be the death of the EIA.

 

The top-ranked product in the eyes of many producers is one that offers a true (read 100%) participation rate, with no caps, and no spreads without requiring annuitization.  Some planners also prefers those “that offer more than one premium account (by using ” sub-accounts” – a concept that has not been fully accepted by the industry as yet) or multiple cash value strategies with multiple indices.”  (Just for fun – guess what industry or discipline this marketing organization is in?  The “multiple-cash-value strategies” and the “multiple indices” give it away as a member of the Banking industry.  They “want their cake and eat it too” – they don’t want to pass up the commissions on the insurance-based product, but then they also would like for the money to come back to their fold in CD’s or other bank-related products.)

 

One large company that markets EIA products says they are presently offering five participation choices on 3 EIA’s.  All are annual reset, and incorporate daily averaging to determine the annual indexed interest rate.  Replying to the requirements of their customers, their plans have guaranteed participation rates, and guaranteed caps or margins, for the entire index period, annual recognition and crediting of index interest and full liquidity of the index account value at the end of the index period (no forced annuitization).

 

The High Water Mark design is attractive to many producers also, which allows the customer to lock in the highest S&P’s index value on each contract anniversary, because historically, the S&P 500 has declined about every fourth year.  The plan also locks in the participation rate and has income options including some the customer cannot outlive and protection against index volatility with monthly averaging.

 

Another insurance company offers a portfolio of three plans.  They are all annual reset designs, with no caps, spreads or vesting formulas.  One of the plans has a 10-year design that has a monthly averaging provision that will return to their customers a better index participation during bear markets.  (Maybe this is the solution to those who are concerned about the S&P 500 dropping…)

 

Still another insurance company who has designed their products as a result of customers’ requests, says that their best seller features a nine-year declining surrender period, full account value upon death, 10% free withdrawals after the first year, 20% nursing home withdrawals, a critical illness waiver, annuitization after the first year, and an annual switch option that allows policyholders to move out of indexed-linked returns and into a guaranteed interest rate product at each policy anniversary.  This company also offers a product that is tied to the S&P 500 and to the Dow Jones Industrial Average (on a 50/50 basis).

 

One company offers indexing linked to the above two plus the Russell 5000.  This plan, which allows multiple interest crediting strategies, allows them to transfer funds between the different strategies without incurring taxes or surrender charges.

 

 

SUMMARY

 

It would be relatively safe to assume that the Equity Indexed Annuity will follow the path of other products and in a few years (or months) there will be a wide variety of plans and options, including several indexing sources.  A lot of the changes in the EIA will depend upon the movement of the stock market, since indexing is the most unique feature of this plan. 

 

In the meantime, the EIA is a new product that fills a particular need in the investment environment.  It is sold primarily by those who are not registered representatives or dually licensed, however many “experts” in EIA’s see a trend towards dual licensing as it is difficult to differentiate the EIA from a securities product in the mind of many investors.  In any event, it is a product that deserves to be seriously considered by the financial planner.

 

 

 

 

1.  How are stock dividends treated in an EIA using the S&P 500 Index?

      A.  They are sold and the money is sent directly to the annuity owner.

      B.  They are added to the growth of the stock in calculating the index.

      C.  The reinvesting of dividends are indicated in the stock average only, not the initial
      dividend.

      D.  The EIA will not reflect dividends.

 

2.  The “Initial Accumulation Term” describes

      A.  the date from which the indexing is calculated for a particular period.

      B.  the time length of the EIA.

      C.  the time between the inforce date and when each premium is due.

      D.  the time it takes the annuitant to earn enough to pay the premium.

 

3.  When Joe buys an EIA and pays $10,000, only $9,000 is invested for him.  The $9,000 is called the

      A.  discount.

      B.  participation rate.

      C.  collar.

      D.  investment ratio.

 

4.  The limit on the amount of indexed interest that can be applied to an EIA during a certain period, regardless of how high the indexes may go, is called

      A.  illegal as it violates securities laws.

      B.  a “cap.”

      C.  the participation rate.

      D.  the “top hat.”

 

5.  If an annual reset EIA has a minimum amount of indexed interest that will be credited to it in any one year, then this minimum is called

      A.  the “cap.”

      B.  the participation rate.

      C.  the “floor.”

      D.  the “cellar.”

 

6.  A percent of each year’s account value at the end of each year, is available from the EIA without penalty.  This is called

      A.  amortizing.

      B.  indexing.        

      C.  consolidating.

      D.  vesting.

 

7.  Which of the following investment vehicles has the higher risk?

      A.  Commodities.

      B.  Variable Annuities.

      C.  Government Bonds.

      D.  Certificate of Deposit.

 

8.  Which of the following types of annuities has the greatest loss potential?

      A.  Fixed-rate annuity.

      B.  Variable Annuity.

      C.  EIA

      D.  Fixed rate immediate annuity.

 

9.  According to recent surveys, which indexing method is used in most EIAs?

      A.  Point-to-point

      B.  High water mark

      C.  Annual reset

      D.  Digital Method.

 

10.  In order to reinforce the non-securities status of the EIA product, the agent should

      A.  reinforce how the EIA differs from a security.

      B.  compare the results of a Mutual Fund with the returns on an EIA.

      C.  represent the EIA as a securities product regulated by the SEC.

      D.  pick a blue-ribbon well-known stock, and indicate the EIA results will be the same.

 

ANSWERS TO STUDY QUESTIONS

 

1D     2B     3B     4B     5C     6D     7A     8B     9C     10A