Public confidence was rattled by the widening mutual fund scandal, first by investigations into abusive trading and more recently by revelations of excessive and often hidden fees. Investors searching for a way to participate in rising equity markets, however, only have to look to the insurance business for a viable alternative.
An equity index annuity (EIA) provides investors not only with a stable, minimum rate of return, but also with the advantage of an equity component that offers the opportunity to participate in stock market gains. With interest rates so low and stocks experiencing a rebound, we've seen a marked increase in demand for these savings vehicles.
What is an equity index annuity? In a nutshell, it is a conventional annuity contract with an equity kicker. In other words, an EIA has all the characteristics of a traditional annuity: It's a contract between an investor (the annuitant) and a life insurance company and is designed to accumulate interest earnings on a tax-deferred basis during either an open-ended period or a set time frame.
Second, and perhaps most important, like all fixed annuity contracts, the initial principal investment is guaranteed. At the contract's end, the annuitant has full access to his or her principal plus earnings, which can be taken in a lump sum or a series of payments during a specified period or the annuitant's lifetime. Or it simply can remain in the annuity tax-deferred. Clients also have access to their money during the contract, but if they choose either to draw down on their contract or cancel it, they're subject to a surrender charge and taxes.
An EIA differs from a conventional fixed annuity in an important way: In addition to carrying a minimum crediting rate over the life of the contract, the issuing insurance company also agrees to add a second potential source of return -- gains derived from a stock market index.
Here's how it works: In each contract year, the insurance company uses a portion of the premium to buy call options on a specified stock market or bond index. Common indices tied to EIA accounts include the S&P 500, the Dow Jones Industrial Average, or a convertible or investment grade bond index. If, during a given contract year, the index's value increases, the insurance company exercises the options and passes a portion of those profits onto the contract holder. If, worst case, the market index goes down every year during the contract, then the insurance company allows the options to expire at no gain and instead credits the policyholder's account with the minimum crediting rate specified in the contract.
Zero Is Good
The true power of many indexed annuities lies in the equity earnings formula's reset function, so that in a down year, the policyholder does not give up any previously earned gains. Any growth in the index is measured from the current reset point.
Consider two scenarios (see the chart below): Someone investing in the stock market who is exposed to the market's full volatility, the great up years but also the years in which the market goes down; and someone investing in an EIA. On average, stocks experience a bear market in three of every ten years. As the chart illustrates, the first saver, who invests $100,000 in the stock market during a five-year period, experiences annual returns of 24%, 16%, 12%, and 14%, but also one year in which the portfolio loses 24%. He will earn less on that portfolio than the second saver, whose annual positive returns are cut significantly but whose loss in the down year is limited to zero.
That's what happens with an indexed annuity. Many such contracts put an earnings cap on the available annual return from the equity index. Even if that cap limits the returns to only 50% of those available, the fact that the annuitant has no downside risk in the event of market declines has an enormous effect on the available return from the contract.
The Ins and Outs of EIA Contracts
Equity index annuities have been around since 1995, but not all EIA contracts are created equal.
How can producers judge among products? An EIA should be viewed for both its guaranteed and potential rates of return. The insurance company guarantees a minimum rate of return based on a certain percentage of the initial premium. At the other end of the return spectrum, producers need to estimate the maximum potential return from the contract based on the current and guaranteed crediting method, index caps, and fees.
Earnings tied to growth in an equity index, coupled with a minimum guaranteed floor, give clients an opportunity they never had before. Other important factors include liquidity features at the time of death, disability, or nursing home stay, as well as the insurance company's strength.
What I Tell Producers
When producers call my office asking for advice on EIAs, here are some of the pointers I provide:
o Surrender charges. For clients facing a surrender charge in a rollover situation from another annuity contract, the producer may want to offer an EIA with a first-year premium bonus credit designed to minimize or eliminate the effect of an early surrender charge.
o Caps and fees. There's no free lunch, and insurance companies protect their profit margins and manage the cost of options by either by placing a limit on the available upside returns credited to EIAs or charging an annual fee. Most carriers charge one or the other, but some charge both; that's not necessarily bad when reviewing the overall earnings formula, but it's important to read the contract for these provisions.
o Interest crediting method. What method does the insurer use on its EIA to credit earnings to the account? Insurers usually apply one of three crediting methods to calculate earnings on an EIA: monthly or daily averaging of the index; "point to point," which measures the index growth over time; or a "high watermark" method. As with the fee versus cap choice, the choice among crediting methods is often a matter of preference for the producer and the client. The best deal for the client often depends on market conditions. When markets are robust, a point-to-point method may serve the client best, but if they're more volatile, an averaging method may work better. Many contracts allow the annuitant to switch among crediting methods annually or even to split the contract among the various crediting options, offering diversification to anticipate various market scenarios.
o The pitfalls. Producers should watch out for what I call the "trust-me" contracts. Some contracts allow the insurer dramatically to change the cap on the equity earnings rather than adhering to a cap that's fixed or has an acceptable minimum floor. Another caution: Some contracts allow the annual fee to change. I suggest that producers instead opt for guaranteed maximum fee structure if that's the pricing route they choose to take.
A Tough Time for Savers
Without a doubt, the past several years have been a brutal time for people trying to build a nest egg. But for savers looking for ways not only to preserve their hard-earned savings, but also safely to grow or make up some lost ground, EIAs are a good alternative.
When producers combine the guaranteed portion of the annuity with the potential upside tied to gains in a stock market index, I usually have seen contracts return 6-8% over the contract's life. Some contracts have returned significantly higher, and for savers bruised by the bear market and worried about their mutual funds, this can translate into a solid shot at running with the bulls again without getting gored.
