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Annuity Products |
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Interest Credits (con’d)
Equity Indexed Annuities
Equity indexed annuities (EIAs) or equity indexed contracts (EICs) — relatively new entries to the annuity market — are a type of fixed annuity that offer the potential for higher credited rates of return than their traditional counterparts but also guarantee the owner's principal. The interest credited to an EIA is tied to increases in a specific equity or stock index (the most commonly used index for this purpose is the Standard & Poor's 500 Composite Stock Price Index). Underlying the contract for the duration of its term is a minimum guaranteed rate, usually 3 or 4 percent, so a certain rate of growth is guaranteed. When increases in the index produce gains that are greater than the minimum rate, that gain becomes the basis for the amount of interest that will be credited to the annuity. At the end of the contract's term — which is usually five to ten years — the annuity will be credited with the greater of the guaranteed minimum value or the indexed value.
Like a fixed annuity, the investments are held in the annuity company’s general assets, not a separate account. But unlike fixed annuities, with a fixed rate of interest (minimum or the current rate the company declares periodically), the rate of interest credited to an EIC is the greater of a minimum rate or the gain on a specified index (usually the S&P 500). In other words, the rate is based on a predetermined formula, rather than the rate the annuity company chooses to pay. Another key difference is that all EICs have a stated term or duration; most other types of annuities do not.
Indexing methods
The interest rates credited to equity indexed annuities are based on changes to the underlying index. But just how are those changes measured? Each contract will spell out in (sometimes confusing) detail, how the index's performance translates into the interest rate paid on the EIC. There are several ways an equity-indexed contract may measure gains and losses in the underlying index — and these can be classified into two broad categories: the annual reset method or a point-to-point method.
In the point-to-point method, the contract looks at the total change between the starting value of the index and the value of the index at the end of the contract's term. Typically, the ending value of the index is divided by the starting value (minus 1) to reveal the rate of gain. For example, assume the starting value of the S&P 500 is 1,300 and the ending value is 1,690. This represents a 30% increase (1,690 / 1,300 = 1.30, then subtract 1.00 for an overall gain of 0.30 or 30%). The annuity’s cash value will reflect that 30% increase. If the contractholder had invested $100,000, the ending cash value will be $130,000 (subject to various limitations discussed below). During the life of the annuity, the investor will not know what the overall rate of return will be — that rate can only be calculated at the end of the annuity's term. Also note, that variations in the index during the life of the annuity are immaterial, only the ending value is relevant to the calculation.
In contrast, the annual reset method takes into account annual performance. The value of the index is reviewed on each anniversary date (or other date specified in the contract). If the index's value is higher on the next anniversary, that positive return is credited to the annuity's cash value. An essential characteristic of the annual reset method is that losses in the index's value are ignored. If the index movement in any year is negative, the contract treats the return as zero and credits nothing to the cash value. For this reason, the annual reset method is sometimes called the ratchet method — changes only occur during positive periods, i.e., the cash value only "ratchets up". Since the annual reset methods looks at results from year to year, gains can be credited, even if the index's current value is less than its starting value. For example, assume the index's starting value is 1,300. At the end of year 1 the index is 1,430, representing a 10% increase. A $100,000 investment will be credited with that 10% gain; the cash value will be $110,000 at the end of year 1. Suppose at the end of year 2, the value drops to 1,350. The negative results will be ignored, and the cash value remains at $110,000. The bear market continues in year 3 and the index drops to 1,250. Again, this loss does not affect the cash value, which remains at $110,000. In year 4, the index rebounds a little to 1,275. This 25-point movement represents a 2% increase over the previous anniversary value (1,275 / 1,250 = 1.02, minus 1.00, equals 0.02 or 2%). So cash value will increase by 2% from $110,000 to $112,200 ($110.000 x 102%). Please note that the contract's cash value increases in year 4, even though the index itself is below its starting value (1,275 vs. 1,300).
There can be considerable variation in how each contract's indexing method is applied. For example, many point-to-point contracts include a "high water mark” provision. With this provision, the company will look at the value of the index at certain times during the contract's life, for example on each anniversary date, and the index's highest value on those dates will determine the gain to be credited to the contract. This protects investors from a significant decline in the index in the later years of the contract's life. While the overall gain will not be credited until the end of the contract's term, the gain will be based on the highest value of the index (as of the specified dates), not simply the ending value. Another way some contracts protect the annuity owner from severe declines in the index is to average index values over time, rather than selecting a single value at a specific point in time. For example, a contract using the annual reset method may rely on each year's average value, rather than the index value on the anniversary date. A point-to-point contract may average the index's value for the final year to measure the gain rather than the value on the ending date. Most EICs use some form of averaging. Averaging has the effect of "driving numbers to the middle" — it prevents the investor from being locked into the lowest index point of the year, but it also guarantees that the investor will never hit the highest point.
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![Text Box: Equity Indexed Annuities versus Index Mutual Funds
At first sight, an annual reset EIC, with its ratchet effect, may appear to always outperform the index. In the bear market example above, an investment in a basket of stocks that mirror the S&P 500's weighting would have experienced a loss, from an initial value of 1,300 to 1,275 at the end of four years. By comparison, the cash value in the annual reset annuity saw an increase from $100,000 to $112,200. But that simple analysis overlooks some key differences.
Investors in a portfolio of the S&P's stocks would receive dividends from their investments. So would investors in an indexed mutual fund or exchange traded fund such as SPDRs®. Those dividends are not factored into most EIC valuations. Put another way, the index measures only changes in the underlying stocks' prices, not the total return (capital appreciation + dividends) of an "indexed" portfolio. Cash values in annual reset annuities tend to outperform the index in periods of high market volatility, but may ignore part of the return available from an investment in the underlying stocks. Historically, dividends account for approximately 1/3 of a stock portfolio's total return.
[Standard & Poor's does calculate a "total return" index related to the S&P 500, to include dividend payments — and this is commonly used to compare mutual fund or other investment performance to the general stock market. Most EICs use the "regular", i.e., no-dividend S&P 500, not the "total return 500" index. Obviously, it is important for financial advisors to know which index the contract uses.]](image338.gif)
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"Moving Parts"
Adding to the complexity of equity indexed annuities are various limitations on how the index's gains and losses are translated into changes in the contract's cash values. These limitations are referred to as the "moving parts" of the annuity. Each contract will have its own unique set of moving parts, and it is important for financial advisors to be aware of how these work, and how they interact with each other. Small variations in these provisions can significantly affect the overall return the annuity owner will actually receive.
One common limitation is a “participation rate”. This is the percentage of change in the underlying index that is credited to the annuity. For example, a contract with a participation rate of 80% would see the contract credited with 80% of the change in the underlying index. If the index were to gain 15% in value, the contract would credit the account with an 12% gain (80% of 15%, not the full 15%); if the index went up only 7%, the contract would be credited with 5.6% (80% of 7%). Some contracts offer "full participation" meaning that 100% of the index's gain is credited to the contract. Annuity companies hedge the sale of EICs by purchasing indexed equity options — this allows them to guarantee the investment within the contract. The participation adjustment is one method annuity companies use to cover the cost of those equity options. The participation rate may be fixed for a period of time, e.g., for the first year, the first few years, or the duration of the contract; while other contracts may allow the company to change the participation rate at its discretion. Some contracts guarantee that its participation rate will never drop below a stated level; others do not. Obviously, a higher participation rate favors investors (all other factors being equal).
A variation on the participation theme is the "yield spread". Instead of applying a percentage reduction, a yield spread subtracts a fixed annual amount from the indexed rate of return. For example, if the annual growth in index in an annual reset contract was 10% and the contract had a 3% yield spread, the investor will be credited with only a 7% gain (10% - 3%). The spread relates to annual rates of return — so in the case of multi-year, point-to-point contracts, the overall gain in the index over the duration of the contract must be annualized before deducting the yield spread.
"Caps" are another way for the annuity company to limit the amount of gain credited to an EIC. Caps are simply a maximum amount that can be credited, regardless of how well the index may do in a bull market. Annuity companies use the cap in bull markets to offset the fact that index losses are ignored in bear markets. Caps may be linked to the index's results (index cap) or linked to the amount that will be credited to the contract (interest rate cap).
For example, an annual reset EIC has a participation rate of 80% and an index cap of 12%. This means that only the first 12% of any year’s gain in the index will be considered in calculating the amount credited to the cash value. If the index increased by 10%, the whole index gain will be used (10% is below the index cap) — and with the 80% participation rate, the contract would be credited with an 8%. If the index gained 20% this year, only 12% (the capped amount) would be used — and that would be further reduced by the participation rate to 9.6% (80% of 12%).
In an interest rate cap, the cap relates to the amount of gain being credited to the contract. Using the same example but changing to an interest rate cap, a 20% increase in the index would be subjected to the 80% participation rate, or 16%, which exceeds the 12% cap — so the contract would credit 12% (vs. 9.6% under the index cap).
A similar process is used if the contract uses a yield spread instead of a participation rate. If the contract had a 3% yield spread and 12% index cap, a 20% gain in the index would result in 9% credited to the account (20% gain subject to the 12% cap; 12% maximum index change less 3% yield spread = 9% actually credited). If this had been an interest rate cap instead, the investor would have been credited with 12% (20% index gain less 3% yield spread or 17%; subject to a 12% maximum under the cap).
As you can see from these examples, there is a complex interaction among a contract's moving parts. What one facet of the contract may offer to the investor can be counterbalanced by another feature. Each contract will have its own unique set of provisions. Before recommending any EIC, financial advisors should be fully aware of the details of that particular contract. Generally speaking, a contract with caps will allow the annuity company to offer higher participation rates, or lower yield spreads, as the cap limits the company’s risk. There are no hard and fast rules to determine whether one contract's set of moving parts are better than another's.
For example, if a contract with a 10% index cap and 80% participation (which allows a maximum credit to the contract of 8%, [80% of 10%]) is not as good as a 9% index cap with a 90% participation rate (which allow a maximum credit of 8.1% [90% of 9%]). EICs are complex investment vehicles and, as always, the "devil is in the details".
The primary purpose of an equity indexed annuity is accumulation. Unlike other annuity contracts, an equity indexed contract has a ‘maturity” date. At the end of the contract period, the accumulated value can be taken lump sum or in the form of annuity payments. In other deferred annuities, the contractholder can decide to annuitize at any time — which makes those contracts a more liquid investment than EIAs.
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