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.
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.
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.
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.
CUSTOMER APPLICATION
Archie purchased an Equity Indexed Annuity a year ago with a participation rate of 90%. This particular annuity uses the S&P 500 index. The S&P 500 rose 10% during the first contract year. Therefore the interest rate applied to the contract would be 9% (.10 x .09).
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.
As an example, a recent survey of the most popular plans of the 15 major writers of EIAs, showed that about half has 100% participation limit, most with no annual adjustments. Others range from 60% or 70% to 100%, and daily average of 55% with annual participation of 60%; daily average of 60% with annual participation of 70%; and others that range all over the spectrum, with 20% at the low end to 65% at the high end.51 The point is that each plan must be carefully studied in respect to the participation limits.
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:
FEquity indexed annuities are designed for long-term investing, and should not be sold to those with immediate or continuing liquidity requirements
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.
A recent survey of the most popular EIAs of 15 insurers indicates that the current participation rate is generally 100% guaranteed with 8 of the plans, most indicate it has never been adjusted. Other plans range from 60% first year with 50% base; to 70%; to 60% daily averaging and 70% point-to-point; to a rather complicated rate of 20% first year with 10% cap, 5 yr. 25%, etc52.
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%. The EIAs recently surveyed showed many companies adjust their CAP annually. Nearly all had both cap on total earnings, and cap on annual earnings.
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.
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.
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. For instance, one popular plan has surrender charges of (percent) 12,12,12,10,8,6,4,0 – applies from date of policy only.
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.
A surrender charge value is determined by some, for instance, as being equal to accumulation value multiplied by the interest adjustment less surrender charges (which vary by length of time the plan has been in force).
Many of the EIAs on the market today have “Asset Fees” or other additional charges. Asset fees are a percentage of the assets of the contract. For instance, one company has a 3.50% administrative charge annual equity strategy, 2.50% convertible and investment grade bond strategies. For the most popular EIAs sold by 15 of the leading EIA providers, only two of the plans have such an asset fee.49
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:
Is the rate guaranteed?:
Is there a minimum guarantee?:
Is there a loss potential?:
Is there, then, the potential for gain?:
How about access to the money?:
Half or 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 these criteria, the following comparisons can be made.
How the growth is determined:
Is the rate guaranteed?:
Is there a minimum guarantee?:
Is there a loss potential?:
Is there, then, the potential for gain?:
How about access to the money?:
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 a few changing from the Standard & Poor’s 500, using instead Dow Jones Industrial Average, the Russell 2000, the NASDAQ 100 and/or different bond indexing – still S&P 500 is the most used. Recently some EIA’s offer the customer a choice, and in some cases, asset re-balancing.
To reiterate –
Fevery 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 is 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.”
CONSUMER APPLICATION
Bruce is an agent for Lucard Insurance Company, and in discussions with his client, it has been determined that the client wants the point-to-point crediting method (an index starting point, and an index ending point). One of the annuities is an annual reset annuity, with an annual lock-in – referred to as the “Reset Protector.” The other annuity is a point-to-point, long-term annuity which measures only the beginning and the ending value of the full index term – referred to as the “Original Index Protector.” Both plans have a 100% participation rate, no cap or margin/fee, and a product term of 3 years. For comparison purposes, the proposal shows both plans purchased on the same day, with $100,000 premium with an annual index starting point of 1,000. For illustration purposes, it is assumed that the fund will be credited with 10% growth.
The Reset Protector (RP) (with an annual reset) grows to an index value of 1,100 at the end of the first year (accumulation value of $110,000). (Continued)
The Original Index Protector (OIP) doesn’t recognize any gains at this point, and continues its merry way, waiting until the end of the 3rd year to credit any gain.
Oh, Oh. Since the market goes down as well as up, assume that the marking has gone down during the second year, and the index has gone down to 900. However, one of the great advantages of an EIA is that it does not credit negative movement. Therefore, the RP will credit a gain of 0% at the end of the second year. But, because of the “lock-in”, the account value is unaffected and remains at $110,000. But, the starting point of the new index term will now be 900.
However, on the OIP, since there is no notice taken of the downturn, the customer will have to wait until the end of the 3rd year to credit a gain.
The assumption is now that for the 3rd year, the index value has climbed back to 1,000. So, what does this do?
The RP credits a gain of 11%, because the annual reset feature allows the retracing of the gain from 900 to 1,000. Guess what? This increased the account’s value by $12,100 because it credited growth in two years, even though the index level returned to the same level as it was on the issue date of the policy. Therefore, the client’s premium has grown to $122,100!
Now, a look at the OIP. After waiting for three years to see what the fluctuations in the market produces, the index value at the end is the same as in the beginning, i.e. 1,000.
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, it would be desirable for an agent to have an EIA with the annual reset and lock-in feature in his/her portfolio.
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 features that are 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 because of failure of the issuing insurers has only occurred once, 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:
F 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 (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.
Again, 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:
CONSUMER APPLICATION
Barbara Whitters is single and is now 55 years old and worrying about what she will do at retirement. She has a good job making about $75,000 a year and she saves about 30% of her income. Because of her frugality, she now has a portfolio of over $1 million, all of it invested in several mutual funds – all of them no-load funds. Barbara is smarter than the usual investor, and when everyone was riding the crest last year, she started thinking that what goes up, must come down. Therefore, she took about 40% of her portfolio last year, and converted it to cash. About 60% of the portfolio is qualified money.
Barbara wants to retire in 5 years and move to Hawaii. She will continue to save at her usual rate until retirement, so she is concerned about getting a lifetime income of about $45,000 a year and she wants to retain her principal at the same time. She agrees that a 3% inflation factor should be considered in planning. She has no family so typical estate planning does not enter the picture.
Barbara invests $400,000 into an EIA now. For the growth over the next five years, she assumes that 8% would be about right and therefore, the resulting principal when she reaches age 60 should provide a lifetime income of $45,000 per year (no period certain). If she used a fixed annuity, it would require more capital “up front” because it would be necessary to assume a lower rate of return. Therefore, by using an EIA there is a higher anticipated return so a smaller investment can be made to accomplish the goals.
Barbara will fund the annuity out of the qualified money. She will also use some of the liquid cash, and will convert some mutual funds to cash. There still will be more than $200,000 in qualified mutual funds, plus the non-qualified investments for future income and cash needs, that will still remain.
Barbara is comfortable using mutual funds as she has been investing in them for years with good results. Therefore, she is also comfortable with the EIAs. The agent can recommend using two EIA’s with different crediting methods, even though the returns over the past few years have been more than adequate to meet the 8% assumption.
The EIAs should also have an indexed payout feature which can handle the need for her to increase her income because of inflation. It can also carry a long-term care benefit which will pay anywhere from 30% to 60% additional benefit if she required long-term care.
This plan has allocated 40% of her portfolio to an EIA with a guaranteed benefit. The 60% will be kept in mutual funds, with annual reviews to make sure that the plan is performing so that she can meet her goals.
The Consumer Application shown above is a practical approach as if a client who has to work for his money has a $1 million in mutual funds, he evidently has some confidence in mutual funds and he would in all likelihood protest if all of the funds were to move immediately to another investment vehicle with which he is unfamiliar.
Another way to accomplish basically the same thing as in the Consumer Application above, but using annuities a little differently, would be by using a “Split Annuity.”
A “Split Annuity” is not a product, actually it is a technique that can be used with either a fixed-premium annuity, or a Variable Annuity. It is designed to allow a certain percentage of the principal and interest to be withdrawn by the contract owner, while the remaining investment grows (and compounds) and with the prospect of eventually equaling the original investment amount.
The concept is simple: The contract owner divides the account into two parts. One part is completely liquidated, and the other part is used strictly for growth. While either a fixed-premium annuity, or a Variable Annuity can be used, obviously only the fixed-premium contract can make the guarantee that the original amount will be completely restored within a pre-determined period of time.
The purpose of the Split Annuity concept is to maximize income and at the same time, keep wealth intact. It also has a tax advantage. The way that this would work can best be explained in the following Consumer Application.
CONSUMER APPLICATION
Bradley has freed up $100,000 because of a market transaction. He wants to have a current income but he also wants to make sure that after a certain period of time, he still has his $100,000. And, he wants to do this and still have a tax break.
Bradley invests approximately $60,000 into a fixed-premium annuity which guarantees a 6% rate of income over the next eight years. He then takes the remaining money (approximately $40,000) that is immediately annuitized for the same period of time – 8 years. The insurance company issuing the annuities furnish the exact amount that can be used to accomplish his purpose.
According to the interest credited by the insurance company, the approximately $60,000 will be worth $100,000 (exactly) at the end of the 8 year period. During this 8 years, he will receive approximately $450 per month (again the insurer will calculate the exact amount).
The tax break develops because 82% of the $450 per month is not subject to income taxes because of the exclusion ratio.
His goals have been accomplished.
As an alternative, Bradley could invest the $40,000 into a variable account that could take advantage of the returns of 12% - 13% growth of the stocks (over the past 50 years). If he had invested 8 years ago, with the recent stock market gains, he would have had substantial growth in his sub-accounts. Just at $12%, it would have grown to over $90,000.
STUDY QUESTIONS
1. A consumer purchasing an EIA that is linked to the S&P 500 index
A. is just the same as buying stock that is listed in the index.
B. is not the same as buying stock because an EIA helps to eliminate the market risk.
C. will get a much, much lower return than one that is linked to the Dow Jones index.
D. will not be able to withdraw any money from the EIA under any circumstances.
2. At the end of the term of an EIA, the contract holder will receive
A. the lesser of the guaranteed minimum value of the contract, or the indexed value.
B. the greater of the guaranteed minimum value of the contract or the indexed value.
C. an additional bonus of anywhere from 5 to 7% of the minimum value of the contract.
D. a return of premium only.
3. The “Initial Accumulation Term” is
A. the time length of an EIA.
B. the interest rate that is guaranteed at issue of an EIA.
C. the first 5-year period of an EIA.
D. the first 60 days when the purchaser can cancel and get a full refund.
4. The percentage of the premium deposit and annuity value that will be applied to the contract is called
A. the participation rate.
B. the accumulation gross amount.
C. the accumulation net amount.
D. an accumulation unit.
5. Equity indexed annuities are designed
A. for the super rich investor.
B. for pre-funding nursing home care.
C. for long-term investing.
D. so that banks and S&Ls can enter the insurance business.
6. Some EIAs have a provision that there will be a maximum interest rate that can be applied to a contract during a certain period, regardless of how high the indexes may soar. This is called
A. a floor.
B. a cap.
C. a deal-breaker.
D. a minimum.
7. For EIAs that determine index interest annually or multi-year, the minimum amount of interest that will be credited to a contract in any one year or over several years is called
A. a cap.
B. a floor.
C. a maintenance fee.
D. the tunnel.
8. “Vesting” of an EIA allows for partial withdrawals or surrenders where a percent each year of the account value is available from the total value of the contract. The purpose of this is
A. to protect the agent’s commission from chargebacks.
B. to differentiate the EIA from other securities products.
C. protect the insurer from early contract surrenders as the insurer invests in financial mar-
kets and otherwise they would have to cash in some of their securities.
D. to keep consumer organizations happy.
9. When an EIA is used for an IRA,
A. pre-notification must be given to the IRS.
B. penalties for partial withdrawals or surrenders must be removed by law.
C. the IRS will question the return every year as the value fluctuates.
D. the contract period must coincide with or be earlier than, the date the annuitant turns age
70 ½ or severe tax penalties will occur.
10. EIAs are purchased by consumers primarily
A. because of the high commissions, agents push them hard.
B. because the consumer is guaranteed that he will beat the stock market results.
C. since the funds are guaranteed by the state insurance department, they are so safe.
D. for the purpose of accumulating savings for their retirement.
ANSWERS TO STUDY QUESTIONS
1B 2B 3A 4A 5C 6B 7B 8C 9D 10D