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A Primer On Equity Indexed Annuities

The name “equity indexed” annuities refers to a class of fixed annuities that credits interest based on a formula that considers changes in an equity index. One of the more common indices is the Standard and Poor’s 500® Composite Price Index (commonly called “the S&P 500®”).

Like all fixed annuities, equity indexed annuities provide that all premiums paid and earned interest are guaranteed and are not subject to market risk. Consumers should not confuse an equity indexed annuity with a variable annuity. To help avoid any mischaracterization, many insurance companies today are no longer using the term “equity indexed” annuities. Instead most are using the term “fixed indexed” annuities or just “indexed” annuities.

How is an indexed annuity different from a variable annuity?

A variable annuity’s accumulation value will change because of the results of its underlying investments. These values are subject to market risk and loss (unless placed in a fixed account). Indexed annuities-like all fixed annuities-provide underlying guarantees of values. Equity indexed annuities usually track two separate accumulations. An accrual of a percentage of premiums at a guaranteed minimum rate of interest stands on its own. A separate accumulation of the full premiums at rates that can be indexed and are guaranteed not to be less than zero is subject to surrender charges. The indexed annuity’s value is the larger of the two. While the traditional fixed rate annuity carries an interest rate that is declared by the insurance company, an indexed annuity uses a different formula to credit interest to the policyholder’s contract, usually tied to a market index. Also unlike variable annuities which are subject to stock market risk, premiums deposited into fixed and indexed annuities are backed by the general account assets of the life insurance company. General account assets include predominantly fixed income securities, not equities.

A buyer of any annuity may lose money if he or she fails to understand the intended long-term nature of annuities and subsequently decides to surrender it too early. Potential buyers should keep in mind that guaranteed credited rates promised by the insurer may be applied to an amount less than the total amount of the premiums, such as 87½ percent. The insurer also may offer an indexed accumulation of 100 percent of the premium but subject to surrender charges for a stated period of time if the buyer surrenders the policy during that period. Surrender charges can be substantial. Some insurance companies may not credit the interest tied to the index if the contract is not maintained for a specified period.

While options may exist for limited access to funds without penalty, premature surrender of an annuity can result in substantial loss of premium. A buyer should consider the intent of the annuity, its benefits, and its risks prior to purchase.

How is interest credited?

The most distinctive difference between indexed annuities and other fixed-rate annuities is the manner in which interest is determined. Fixed-rate annuities credit interest at a rate guaranteed in the contract or at a higher rate, typically declared by the insurance company one year in advance. Indexed annuities credit interest over a period, like a policy year, based on

  • an indexing method (that is, a formula) defined in the contract,

  • variables that are used in the formula, like a participation rate and a cap, explained below, typically declared by the insurance company in advance, subject to guarantees in the contract, and

  • the movement of the defined index over that period.

Many indexed annuities today provide multiple accounts in the same contract that can provide different formulas or indexes from which the owner can choose. In some of these, the choice is locked in once made, while in others the owner can reallocate values from period to period. A typical multi-account indexed annuity provides one option that uses declared interest, not linked to any index, similar to a fixed-rate annuity.

Most fixed deferred annuities have surrender charges for a period of years after issue. The relative assurance that the annuity will stay in force allows the insurance company to invest in longer-term fixed income instruments. This would not be the case without surrender charges. This is true of indexed annuities as well. The upside is that this usually produces higher income that can allow for higher interest, higher participation rates and caps, and lower spreads or fees. Because of this, it is important to understand the contract’s features before buying.

Surrender charges come into play only when the owner chooses to withdraw or surrender the money from an annuity before the date agreed on in the contract. Like a CD penalty for early withdrawals, surrender charges also are early withdrawal penalties. Again, a surrender charge’s purpose is to enable the insurance company to invest on behalf of their policy owners in bonds and/or mortgages with fixed durations and with some assurance their own investment can remain in these fixed-income instruments.

Indexing Methods

Different companies provide different indexing formulas, and some companies can provide different formulas, sometimes within a single contract. A few of the common methods include these.

  • Point-to-point: This method measures the gain in the specified index from the start of the period to the end as a percentage.

  • Point-to-average: Similar to the point-to-point method with the gain measured from the index level at the start of the period but differing in that the average of the index level over the period is used rather than the level at the end of the period.

  • High-Water Mark: The gain in the index is measured from the beginning of the period to the highest value of the index during the period.

  • Low-Water Mark: The gain in the index is measured from the lowest value during the period to the value at the end of the period.

  • Monthly Averaging: The gain is the sum of the twelve monthly increase percentages during the year, each subject to a maximum cap but no floor. The sum is then subject to a floor of zero.

  • Variables Used in the Formula
    Participation Rate and Cap: A portion of the defined gain (often called a “participation rate”) is then applied to the value in the annuity, subject to a maximum of a “cap.” The “participation rate” and “cap” are declared at the beginning of the period, subject to guarantees in the contract. A participation rate can be equal to, less than, or more than 100%. The cap might be, say, 4% or 6%. The economic conditions of the period can affect both the participation rates and caps.

  • Floor: The minimum amount of interest “credited” to the principal, typically zero. This ensures freedom from loss when the defined gain is less than zero.

  • Margin, Spread, or Administrative Sales Charge: The company may deduct an amount that might be termed a margin, a spread, or an administrative charge. Often this is expressed as a percent. The insurance company will deduct it from the index gain before application to the annuity’s value to produce an interest credit. Most often, it does not reduce the gain below zero.

Regulation

Many insurance companies issue fixed annuities, including indexed annuities. State insurance departments regulate these products and approve the forms. Fixed-rate and Indexed annuities are not government or bank obligations. They also are not FDIC insured. They are not securities, and the Securities and Exchange Commission does not regulate them.

Also, many companies and states have implemented new compliance and suitability guidelines. It is also important to note that in the rare instance that an insurance company has financial troubles, there is a state guarantee fund available.

Characteristics of the Indexed Annuity

An indexed annuity may limit the interest that may be credited in certain rising markets, but most guarantee against loss of premiums paid and earned interest in a market that declines over the measuring period.

For any method in which all increases are locked in going forward, such a method can be referred to as a “ratchet”-the values cannot go down. Also, whatever value is available at the end of a period is used as the starting point for the next period.

Much of the value of an indexed annuity is the ability to credit zero interest. At first, this may seem counter-intuitive. However, if the guarantee of zero comes to play, having the annuity’s values exposed to market risk would have produced a loss. A big loss due to equity exposure can take many years to overcome. In such a period, the ability to credit zero-that is, not to lose value-constitutes a major benefit.

It is important to understand that the values of an indexed annuity are not invested in the index or in the equities underlying the index. Most of the investments made by the insurance company backing amounts in indexed annuities are required to be in safe, solid fixed income investments, such as highly rated bonds and mortgages. With a portion of the income generated by these investments, the insurance company buys derivative instruments. These produce the “indexed interest” that is used to credit the annuities.

A degree of “liquidity” is usually available during the surrender charge period. Most contracts offer a penalty-free withdrawal each year—often 10 percent of the annuity’s value. Also, these contracts allow the owner to annuitize the entire value without surrender charge to produce an income, perhaps for as short a period as five years. There also are riders available that can provide a guaranteed stream of income for life, typically called a “guaranteed lifetime income rider.”

Is An Annuity Right For You?

The answer depends on your financial situation, your health, and goals. For some, an annuity can be a suitable part of an overall financial plan. For others, the same annuity can be unsuitable. You should think about what your goals are as well as the risk you are willing to take.

It is important to know whether an annuity fits your situation before entering into a contract. Individual needs change with time, and what may have benefited you in the past may not be in your best interest now. Do your homework and ask questions. Never jump into buying something you don't understand. Think about your long-term goals.

Some of these products carry high surrender charges during the early years of the contract should you withdraw your money. Always ask about the drawbacks, not just the benefits. It also helps to talk to individuals that have your best interest in mind, such as a family member and/or tax consultant before making a decision.

Ask yourself the following questions:

  • How much retirement income will you need in addition to what you will get from Social Security and/or a pension plan?

  • Will you need that additional income only for you, or for you and others?

  • If you put your money into an annuity, will you have enough money to cover your expenses before the annuity’s payout?

  • How long can you leave money in the annuity and does the annuity let you take out money when you need it?

  • How long does the surrender charge period last? Can you afford to lock up this money for several years?

  • Is this a single premium (lump sum) or a flexible premium contract?

  • For a fixed annuity, what is the initial interest rate or indexing variables and how long are they guaranteed?

  • Can you get a partial withdrawal without paying surrender charges and/or other charges? If so, how much of a partial withdrawal can you take without being penalized?

  • Is there a death survivor benefit? Are surrender charges assessed against the death benefit?

  • Is a guaranteed stream of income something you want at retirement?

  • Might you need access to your money during the deferral period for unexpected family emergencies or for long-term care or health care?

Any company and agent with integrity will give full and understandable disclosure of the annuity’s characteristics and features. With this information and with the assistance of advisors and/or family, you can make an informed decision.