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
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
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.
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.
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.)
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.
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.
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 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?
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.