Basics
of the Equity Indexed Annuity
An equity (or fixed) indexed annuity is characterized primarily by how
its interest is credited. Index annuity interest crediting is tied to a
market index, such as the S&P 500. If the index rises over the
annuity's term, some portion of that increase will be credited to the
contract. At the same time, underlying the contract is a guaranteed
minimum rate of return. At the end of the annuity's term, the greater
of the indexed interest or the guaranteed minimum will be credited to
the contract. In this way, indexed annuity owners are given the
potential for higher interest rate crediting associated with a market
index, with the assurance that the credited rate will be no less than
the minimum amount stipulated in the contract. Equity indexed annuities
offer the opportunity for greater return than traditional fixed
annuities (though slightly more risk) and less risk than variable
annuities (with less potential return).
Components of the Equity
indexed Annuity
The performance of an equity indexed annuity is affected by various
components, which are ever changing. These "moving parts" have a
profound effect on the EIA's performance. Understanding these parts,
how they may move, and what effect the movement will have on the
annuity is essential for the practitioner and client. The moving parts
reflect the true costs associated with equity indexed annuities. They
are the methodology insurance companies use to maintain profitability.
These moved parts include:
- participation rate
- interest rate cap
- asset fee
- interest crediting methods
- term
Participation
Rate
The primary attractiveness of the fixed indexed annuity is tied to the
participation in a market index. The participation rate is an amount,
defined as a percentage, which is multiplied by any gain of selected
index over a stated time period. It measures the percentage of
participation of the increase the index that is to be credited to the
annuity account value for the prescribed indexing period.
For example, a participation rate of 80 percent would result in an 8
percent crediting rate if the in to which the contract is tied
experienced a 10 percent gain (.80 x .10 = .08). This rate is guarantee
some annuities, but it may not be guaranteed in others. The
participation rate may move up or do depending on the insurance company
issuing the annuity. Participation rates may vary greatly between
annuities and between insurance companies. So understanding how the
participation rate works with the indexing method used is essential.
Other contract features may also offset a high participation rate.
Moreover, an insurance company may offset a large participation rate by
offering contract features such as averaging or an annual reset
indexing method.
Interest
Rate Cap
Some annuities may incorporate an upper limit, or "cap," on the indexed
interest rate that will be credited to an annuity. A cap reflects the
maximum indexed interest rate that the annuity can earn over a stated
period of time. A cap may be the only moving part in an EIA or it may
be incorporated with a participation rate. For example, using the
previous example with an 80 percent participation rate, if the contract
in question had a 7 percent cap, the indexed interest rate credited
would then be 7 percent, and not the 8 percent as discussed in the
previous example. Caps are seldom used with an asset fee or margin
spread.
Asset
Fee (Margin, Spread, or Administration Fee)
The asset fee is used to subtract a predetermined percentage, as
defined in the contract, from the calculated change in the index. This
fee may be in place of, or in conjunction with a participation rate.
For example, if the calculated change in the index is 12 percent, then
the annuity may specify that an asset fee of 2 percent will be
subtracted from the indexed amount before it is credited to the
annuity's account. If the annuity has a guaranteed minimum rate that
would be credited to the account, then the asset fee would only be used
if the indexed amount was more than the minimum rate.
For example, a 10 percent gain in the selected index would first be
reduced by the 2 percent asset fee. The remaining 8 percent would be
credited to the account, providing there were no other working parts
that would impact the calculation of the fee.
(Other terms for asset fee include "administration fee," "margin," and
"spread." They all function in the same way. For the sake of
simplicity, this course will refer to this fee as an asset fee.)
Simple
vs. Compounded Interest
Certain annuities may pay simple interest during the index term. In
this case, the indexed interest is credited to the annuity account but
does not compound during the indexing term. Other annuities may allow
compounding during the index term, which means that indexed interest
that has already been credited also earns interest in the future.
Term
The term of an equity indexed annuity is the period over which
indexed-linked interest is calculated. The indexed interest is normally
credited to the annuity at the end of the stated term. Terms may be
anything from one to ten years, depending on the product or insurance
company. If an annuity has consecutive terms, then money may be taken
out without penalty at the end of the 30-day period following the end
of each term. Some annuities that have multiple strategies will allow
the policyowner to switch strategies at the end of the stated term
period. Multiple strategy switching may also be allowed at the end of
each policy anniversary date.
Vesting
Some annuities will not credit any of the indexed interest rate
accumulation if the policy is surrendered before the end of the term.
Others will credit part of the amount. The amount that will be credited
is stated as "vested." Your clients should know the vesting rules of a
policy before buying it.
Surrender
Charges
Surrender charge periods can vary between zero and 20 years. Although
high surrender charges and long surrender periods were more prevalent
in the past, the industry is being forced to lower charges and time
periods. The so-called 10/10 rules imposed by an increasing number of
state insurance departments dictate that products offered for sale in
those states do not exceed a ten-year charge period or a 10 percent
scale. This 10/10 rule has affected the design of newer products,
including bonus offerings and potential commission schedules.
Notwithstanding, it is still common to see fixed indexed annuities that
impose 16 years of surrender charges.
Because the 10/10 regulations are not uniform but are state-specific,
you will notice product disclaimers about which states offer a certain
product and which states do not. A product with high surrender charges
and a long surrender term period will be available only in those states
that have not instituted the 10/10 rule. As more states adopt this
rule, products will be dropped and will no longer be available, giving
way to the newer products that qualify under the rule.
Practitioners who practice in a state that has not currently adopted
the 10/10 rule face a dilemma. Should you place the client in a high
surrender charge product with a long-term period of charges, or should
you offer a product version that complies with the 10/10 rule, even
though the state has not ye established the rule? Does the high
surrender charge product with a long-term period of charges have any
benefits that the client would not be able to get with the 10/10
qualified products?
How
Does the Equity Indexed Annuity Work?
In a traditional fixed annuity, most of the premium is invested in
long-term government or investmen grade (usually ten-year) corporate
bonds. Assume that these investments return 7.5 percent. First the
company takes deductions for company expenses, commissions, excess
reserves, and corporate profit Then the company credits the remainder
of the interest to the contract. If, for example, these deductions were
2 percent, then 5.5 percent compounded daily would be credited to the
traditional annuity accumulation account.
An equity indexed annuity works in a uniquely different way. Because it
incorporates the same basic features found in a fixed annuity, plus the
guarantee of participation in the gains of the selected market index,
some changes in the company's underlying investment philosophy are
necessary.
For an equity indexed annuity to work, two things must happen:
- A portion of the premium goes to buy a call option on some type of index. This call option works like any other in that it gives the company the right, but not the obligation, to buy the index. At some future designated point in time, the option must be exercised or it expires. Th call option allows the credited interest rate on the annuity to fluctuate as the index fluctuates. Some of these funds would have been credited to the annuity account in a traditional fixed annuity, but with the indexed annuity, they will be used to buy this call option. This is one reason why the guaranteed interest rate on an EIA for any certain term is usually less than that of a straight fixed annuity. Because the cost of the option may be greater than the remaining amount available from the investment, adjustment factors such as participation rates, caps, or fees are required. (Adjustments are covered in more detail in a later chapter.)
- To cover the policy guarantees attached to it, an amount of premium is invested in government or high-quality corporate bonds.
