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Equity Indexed Annuities Before
beginning, please read the following instructions:
Exam
CHAPTER 1: Annuities In General CHAPTER 1: Annuities In General All
annuities have many things in common, so this chapter deals with items
that are generally applicable to all annuities even though there may be
individual exceptions. Terminology may change from company to company as
well as descriptive content, but as a product class, they are similar. An
annuity is basically a contractual agreement between an annuity owner and
an insurance company. The owner makes purchase payments in exchange for
certain benefits and privileges. All annuities are generically known as
tax-deferred annuities. As a product class, there are two general types of
annuities: variable and fixed, which include Equity Indexed Annuities
(EIAs). Annuities share the following features:
Purposes of Annuities Originally, annuities were created to provide an income stream for a specific period of time or during one’s lifetime. Unlike life insurance, which creates an estate and protects against dying too soon, annuities liquidate an estate and protects against living too long. During the accumulation
phase, the annuity owner would deposit with the insurance company a
one-time or periodic premiums to build up a nest egg and then at a
designated time would annuitize the policy. Annuitization describes the
event when the policy owner basically surrenders the accumulated policy
value in exchange for a calculated amount for a specific timeframe or over
the annuitant’s lifetime. Today, however, it seems times have changed. More people are interested in annuities as savings or investment alternatives as well as the guarantees and tax benefits. Annuities are perceived more as accumulation vehicles instead of income vehicles because less than two percent are annuitized into an income stream while the rest are left to heirs. Safety As with any savings or
investment, safety lies with the issuing entity. For annuities, safety
lies with the strength of the issuing insurance company. One can determine
an insurance company’s financial strength by looking at its rating from
A. M. Best Co., Inc., which has been providing
financial strength ratings and evaluations for insurance companies since
1899. On the default side of things, each state has its own insurance guaranty act that protects, up to a certain dollar amount, each insured of an insurer that becomes insolvent. The dollar limits depend upon the type of policy, for example, net life insurance death benefits ($300,000), net cash values for life insurance ($100,000), and net cash values for annuities ($100,000). Liquidity Liquidity can be perceived from two perspectives. In its purest sense, liquidity refers to the ease and speed in which an asset can be converted into cash. In a general sense, it is the same without incurring loss. Notwithstanding surrender charges and an insurance company’s ability to withhold cash payments for up to six months, which is rarely done, an annuity is fairly liquid. The only real hurdles are completing the insurance company’s required paperwork and going through their logistical process, which can sometimes be slow. Risks There are many types of
risks savers and investors are concerned about; however, some of those
risks are either mitigated or nonexistent in annuities. All annuities,
fixed and variable, have some sort of guarantees. Even variable annuities
have an option whereby the principal and interest is guaranteed, if
available, just like any other fixed annuity, but the annuity owner must
expressly choose that option. Of lesser importance, fixed annuities are subject to interest rate risk. Even variable annuities with a fixed component are subject to interest rate risk. Since annuities are usually very competitive with other interest bearing accounts, this is not a major issue. Fixed annuities are not exposed to investment risk like other investments - which is the risk inherent in the individual investment itself - because the principal and interest are guaranteed by the strength of the insurance company. Variable annuities, on the other hand, are subject to investment risk just like the risks associated with investing in mutual funds. Fixed annuities are also not subject to market risk like other investments. Market risk is the risk of loss associated with a large number of assets like the stock market. Suitability and Switching Some states have enacted legislation pertaining to the suitability of the sale of annuities to seniors and has become such a big issue in the VA market that the NASD is taking a closer look at this practice. How does one determine if a particular VA is more suitable than the next, providing a better cost/benefit scenario? Of course, opinions in the investment industry are fairly diverse. One can only assume, if he dare, that in an efficient market all investments have similar risk-adjusted performance. If this is the case, one may want to go beyond the accumulation phase and look at the annuitization phase. Since risk is tied to suitability, then risk-adjusted performance makes for an inefficient measuring rod for switching purposes. The annuitization phase highlights contractual guarantees, which for purposes of comparison can discount various payout scenarios to present value benefits. From this point, one can include hard costs such as mortality expenses, surrender charges, etc. However, one must realize that annuitization of a VA is a rarity. Anyway, one needs to wisely pick his medicine just in case it comes under NASD scrutiny. Replacements A replacement can sometimes be a confusing and complex topic, especially for potential clients. This has led to the heightened concern of regulators who are more closely monitoring business practices of companies and agents. Most companies have already taken a proactive role in issuing internal guidelines and suggested practice requirements for their agents. Insurance companies do not encourage or condone replacing existing annuities as a mode of doing business if such replacements are not in the best interests of the client. Each state has its own set of insurance regulations dealing with replacement. The following is a generalization of when a replacement occurs:
AND
If all policies currently owned by the client remain as is after the new purchase is made, a replacement has not occurred. In order to comply with
replacement regulations, insurance professionals should generally engage,
at a minimum, in the following procedures:
None of this should lead
one to conclude that all replacements are bad, which can be quite the
contrary. One must look and compare all aspects of the new versus the old,
considering the short-term and long-term benefits to the client. Such
factors to consider may include:
Exam CHAPTER 2: Features and Benefits EIAs have many features and benefits that other alternatives do not. Depending upon one’s risk tolerance, investment objective and planning needs in general, EIAs are probably going to have a fit in one’s financial profile to some extent. The following is a list of the common attributes found in EIAs but not found in other saving or investment vehicles. Principal Guarantee Unlike investments, EIAs have some sort of guarantee for the return of principal or premium payments, less applicable surrender charges, assuming one is past the initial free-look period. Of course, this guarantee lies with the strength of the insurance company that issued the policy; and, is further guaranteed by the insurance company’s state of domicile’s Insurance Guarantee Association (now that’s a mouthful). EIAs are not, however, insured by the FDIC, which will probably not be a point of contention with most annuity buyers. Even though it is uncommon for insurance companies to become insolvent, it has happened in the past and will probably happen again. Nonetheless, because of the protection afforded by each state’s guarantee association, it is unlikely an insured would lose money if he followed through with the association’s claims procedures and stayed the course. Interest Rate Guarantee Generally, fixed annuities have two interest rate guarantees. The first is the minimum interest rate that the contract guarantees to never fall below. The second is the current interest rate that is guaranteed during a specific period, usually one year. For the EIA, this rate is determined by an index. Some annuity contracts guarantee a stated interest rate from one contract year to the next. For example, if the date of an annuity contract is July 4, the stated interest rate will be guaranteed until the following July 4 and will be credited to all contributions made during that time. Other companies guarantee the rate for one year per contribution. For contributions made in the month of January, the stated interest rate is guaranteed until the following January. For contributions made in February, the interest rate is guaranteed until the following February, and so on. The source from which the contributions came is irrelevant. The current interest rate is based on the company’s portfolio rate. An insurance company can invest in a wide range of securities, but most are invested heavily in investment grade corporate and government bonds. The weighted yield of this portfolio is what drives the interest rate of a fixed annuity, which is a little below the company’s portfolio rate. This guaranteed interest rate could either be the nemesis or savior of the fixed annuity market. During the bull market of the 90s, investors abandoned traditional fixed products and sought EIAs and their sexier cousins, variable annuities. The bears showed up in 2000-02, so traditional fixed products found favor with investors once again. This was short lived, however, because the Feds drove down interest rates in an attempt to jumpstart the economy. Up through 2005, interest rates have been the lowest in decades, so the likelihood of rates rising and fixed annuities being restored to an honorable position is likely. On the default side of the equation, in 2014 the youngest of the baby boom generation will turn 50. With this being the wealthiest generation of all time, they are sure to restore some of the glamour fixed products have lost to the equities arena. Death Benefit Guarantee All annuities have some sort of death benefit, which is typically defined as the amount that is payable as a result of the death of an owner before the maturity date or annuity date. The amount of the death benefit is usually the accumulated value excluding any surrender charges. Since an annuity is also considered a life insurance product, the amount paid bypasses probate and goes directly to a named beneficiary. If there is more than one owner, ownership passes to the remaining owners. No Fee Structure Unlike variable annuities and many other investments, fixed annuities don’t charge fees. Normal fees from investing can come in the form of administrative fees, operating fees, management fees, etc. This does not mean that insurance companies don’t pass along their costs, they just don’t show up as a fee and one cannot discern otherwise. Fixed annuities also don’t have a mortality expense for death benefit guarantees, as do variable annuities. Policy Loans The general tax rule states that loans from “qualified employer plans,” which includes certain annuities, are considered distributions and therefore taxable. In regards to this rule, qualified employer plans include 401(a), 403(a), 403(b) and government plans. However, there is an exception to the general rule in IRC 72(p)(2), which only applies to certain tax qualified plans. It allows loans that are the lesser of (1) $50,000 or (2) the greater of the annuity’s surrender value or $10,000. Policy loans are to be repaid within five years, per the terms of the loan agreement, unless the loan is for the purchase of a home that is to be used as the principal residence of the borrower within a reasonable time. Tax-Deferral One of the most popular aspects of an EIA is that the earnings grow tax-deferred, whether it is non-qualified or tax-qualified. In performing a comparative analysis, clients and advisors are interested in the bottom line, that is, what are the after tax results of any given investment. For example, if an EIA were earning 6%, what would be the after-tax equivalent for an alternative such as a mutual fund? The quickest measuring tool is to take the EIA yield and divide it by 1 minus the tax bracket. If a client is in the 28% tax bracket and the EIA in consideration is earning 6%, the taxable equivalent would be 8.33% (.06 / (1-.28)). On the other hand, if one had a taxable investment that earns 10%, the equivalent tax-deferred yield would be the taxable yield multiplied by 1 minus the tax bracket. In this case, the tax-deferred equivalent would be 7.2% (.10 x (1-.28)). Of
course, when considering EIAs, one is usually more interested in just
the bottom line, such as lifetime income, survivor income, guarantees,
safety of principal, tax planning, etc.
In a manner of speaking, annuities have triple compounding because
they earn interest on (1) the principle, (2) interest on accumulated
interest, and (3) interest on deferred taxes.
Interest bearing investments or saving vehicles earn interest either on a compound or simple basis. Annuities earn compound interest. The difference between compound and simple interest can be staggering, for example, let’s consider the following investment, excluding taxes.
It doesn’t take a rocket scientist to figure out that compound interest is the only way to go. In 30 years, the total difference is $182,194, which is derived solely from the additional interest earnings. Some
folks think that the tax-deferral of annuities is not advantageous because
taxes ultimately have to be paid. It is true that taxes have to be
eventually paid, but because annuities have triple compounding, the net
after-tax result will always be higher. Triple compounding means that
interest is earned upon the principal, deferred interest and deferred
taxes. Let’s use the same scenario as above and compare the taxation of
the results at the end of the 30-year period to paying taxes along the
way.
Now, there needs to be some additional observations. It is very rare for an annuity owner to cash out an annuity upon maturity and pay all the tax at once. If you have heard of such an instance, you may be the first. In fact, less than 2% ever annuitize the contract while the remaining pass on to beneficiaries who have various options depending upon the tax status of the annuity and relationship to the owner/annuitant. Assuming the remote chance that one did cash out, the tax rate would of course be higher than 28% because of the amount involved. Well, let’s move from a tax rate scenario (above), the rate at which the whole amount gets taxed, to a tax bracket scenario. The 2004 IRS table shows that the highest tax bracket is 35% for a taxable income over $319,100. More specifically, the tax is $89,753 plus 35% of the amount over $319,100. Using their formula, and assuming all of the $332,194 in interest is taxable income, the most that one could be taxed is $94,336, which varies little from our tax rate example above ($93,014). In the IRS’ 2004 tax bracket system (Schedule Y-1, Married filing jointly or Qualifying widow(er)), the first $14,300 of taxable income is taxed at 10%. From $14,300 to $58,100, the amount is taxed at 15%. From $58,100 to $117,250, the amount is taxed at 25%, and so on. This ratcheting system continues until it peaks at the 35% bracket. If we convert our result to an equivalent tax rate, it would be 28.4% (94,336 / 332,194). Tax-Free Exchanges The Internal Revenue Code (IRC) allows annuity owners to exchange one annuity for another without suffering any tax consequences. Like the advantages of tax-deferral, annuity owners are not hindered from closing out one annuity in order to open up another that may be more in line with the owner’s objectives. However, in order to not give the perception of being in constructive receipt of the money for other purposes and to stay within allowable time frames, it is best for any exchange to take place between the insurance companies and leave the annuity owner out of the process. Probate Bypass Upon death, all assets of a deceased person are subject to a state’s probate laws unless some provision is made in the titling, ownership or otherwise to bypass probate, which is the default way of settling an estate. Annuities have beneficiaries and any such designation bypasses probate and the death proceeds go straight to the beneficiary regardless of the terms of any will or trust. Even though the death benefit may vary from company to company, generally, it is the accumulated value at the date of death void of any applicable surrender penalties. Premium Bonus For contracts that have these features, an immediate interest rate is credited to any new premium received by the insurance company, is part of the contract guarantees and subject to surrender charges. Premium bonuses and agent commissions have an inverse relationship; that is, the higher the bonus to the annuity owner, the lower the commissions to the agent. Premium bonuses also have a compounding effect. For example, a $100,000 premium with a 6% bonus will start earning interest on $106,000 instead of $100,000. At a 5% crediting rate, the first year annualized return will be 11.3% instead of 11%. Another type of bonus is one that pays a small bonus each contract year such as 1% a year for the next 10 years, which is payable on the contract date and each subsequent policy anniversary. For example, a $100,000 annuity with ABC Annuity Company is credited $1,000 when the contract is issued as well as each policy anniversary up to a maximum number of years. One advantage of a bonus is that it may be used to offset a surrender charge incurred from surrendering an unsuited annuity and exchanging to one more suited to the annuitant’s needs. For example, Client A has received an inheritance and no longer needs his variable annuity. He surrenders his variable annuity from ABC Annuity Company and incurs a 5% surrender charge, but his new fixed annuity pays a 6% bonus. On the downside, one should be aware of the new company’s crediting history. As the bonuses get higher, beware that crediting rates after the first year may be significantly lower than an existing annuity or one with lower or no bonus. As with any perceived freebie, there is always a trade-off. Higher bonuses usually have strings attached such as longer surrender periods, higher surrender charges and forced annuitization to keep the bonus. For EIAs, an additional tradeoff may be lower participation rates. Consequently, surrendering in the early years with such a scenario can be very costly. For the agent, the trade-off is usually a reduction in commissions. Forced annuitization is an exception to the rule, but a costly feature nonetheless. Of the few annuities that do require annuitization to receive bonus credits, or index credits with EIAs, the penalties for doing otherwise can be very draconian and should be avoided. In order to be deemed compliant, the typical minimum payout is five years but may be longer. Market Value Adjustment (MVA) A MVA is an adjustment made to the annuity’s cash value, depending upon whether interest rates have risen or fallen since the contract’s inception, when the annuity is surrendered or money withdrawn before its guaranteed term or period has expired. For annuities with this feature, they are usually offered with various time periods in which a specific interest rate is guaranteed; and, when they mature, they can automatically be renewed for the same or another guaranteed period. Comparatively speaking, the effect of a market value adjustment is like a bond, which has a principal adjustment as interest rates move up or down. If interest rates have risen since the start date, the adjustment will be negative. If interest rates have fallen since the start date, the adjustment will be positive. When one surrenders an annuity early or makes withdrawals, surrender charges and amounts are known. However, a MVA is the only cost of surrendering or withdrawing early that is an unknown. Surrender Charge All annuities charge a penalty if part or all of the policy is withdrawn during the surrender period, which is a specific number of years in which a penalty would apply. Once the surrender period has passed, no charges apply to any surrender. Of course, surrender charges are inapplicable if the policy is annuitized or cashed in by reason of the owner’s death. Why do annuities have surrender charges and other investments do not? When an insurance company issues an annuity policy, they pay commissions to the underwriting agent, buy securities that will cover the guarantees and have overall operating expenses. In case an owner cashes out early, the insurance company wants to ensure that these costs are recovered. The amount of the penalty is based on the number of years that have elapsed since the receipt of premium payments or the contract date and is typically a percentage of the premium payments or accumulated value. The policy may have a table of surrender charges shown on the data page. If the policy is completely surrendered, the company may require the policy to be returned and reserves the right to defer payment of any surrender for up to six months. In order to forego paying a surrender charge, policies allow an amount to be withdrawn without penalty, called a penalty-free withdrawal. The dollar amount of the surrender charge will be determined by multiplying the applicable surrender charge percentage by the withdrawal amount in excess of the penalty-free withdrawal. For example, if a policy allows up to 10% of the policy’s accumulated value to be withdrawn per contract year, then any amount over 10% will be subject to the surrender charge. Table of Surrender Charges There are typically two different ways in which companies apply surrender charges. The first is based upon policy year. For example, if a withdrawal exceeds the penalty-free withdrawal amount, the applicable surrender charge or percent is determined by the contract year in which the withdrawal takes place. The second is based upon each payment received. For example, every premium submitted, the initial and any subsequent premiums, is subject to a surrender charge.
Nursing Home / Terminal Illness Waivers Many policies allow penalty free withdrawals if the annuity owner is confined in a hospital, hospice facility or nursing facility. Confinement must be for a minimum number of days, say 60 consecutive days, for example. The insurance company will require documentation from a physician that the confinement was medically necessary and due to an injury or sickness. Social Security Not Taxed Social Security (SS) benefits make up a substantial portion of most retirees’ income. Prior to 1984, SS benefits were not taxable, but since SS issues are a political ping-pong, the Social Security Act was amended in 1983 to pave the way for SS taxation. Unless an item is excluded by law from taxation, the IRS says that generally all income is taxable. One of the exclusions is tax-exempt interest from municipal bonds; however, this interest is included in determining whether SS benefits are taxable. The only exception to current taxation and SS taxation is interest earnings from annuities. One just needs to move as much money as reasonably possible from other investments or saving vehicles into annuities to eliminate or mitigate the effects of SS taxation. This topic will be discussed more later. Exam There are many ways to purchase an annuity along with various tax strategies and consequences. Any annuity purchaser must become knowledgeable with each of the options to determine which one best fits his needs. Also note that each of the options below is not applicable to all EIAs. Fixed Annuities Generally, there are two types of annuities, fixed, which includes EIAs, and variable. Fixed annuities are probably the simplest in the annuity arena and are either deferred or immediate as it relates to the timing of annuity payments to the annuitant. In terms of taxation, they are either non-qualified or tax-qualified. Fixed annuities do not have market risk because they are not invested in the stock market. Annuity owners don’t share in any investment risk because the insurance company assumes that as it manages its own investment portfolio. Assuming the definition of interest rate risk includes the loss of principal due to interest rate fluctuations, fixed annuities are not subject to interest rate risk. Deferred Annuities A deferred annuity one that has an accumulation phase of at least one year. This is more of a descriptive term meaning that it is allowed to earn interest and then annuitize at least a year later. Typically, however, annuity owners have their annuities deferred for their whole lifetime. Deferred relates to the postponement of making income payments to an annuitant as well as the deferment of paying taxes on interest. Deferred annuities have withdrawal penalties applicable during the first few years of the contract if one withdraws an amount above a specific percentage, which is the penalty-free withdrawal. Of course, there are exceptions to this rule, such as when the contract is annuitized and the annuitant receives monthly income payments or the owner or annuitant dies. The vast majority of annuities are deferred annuities. Immediate Annuities (IAs) An IA is an annuity that generally has no accumulation phase because it is annuitized shortly after a one-time single purchase payment is made. The annuitant may start receiving payments within a month of the issue date or sometime later, generally before the end of the first year. Annuitization is exchanging the initial purchase payment for an income stream for a specific timeframe or as long as the annuitant lives. Since deferred annuities make up the bulk of all annuities, only a small percentage of annuities are considered immediate. Flexible Premium Deferred Annuity (FPDA) A FPDA refers to the manner in which payments are made to a deferred annuity. It can be funded with one or more purchase payments with the most common being periodic payments. They can also receive irregular payments at the whim of the annuity owner. Irregular and one-time payments are subject to minimum dollar amounts; however, if the annuity owner agrees to regular and periodic payments, the minimums are much lower. Generally, an FPDA must be in effect for a year before any penalty free withdrawals can be made. Single Premium Deferred Annuity (SPDA) A SPDA refers to the manner in which payments are made to a deferred annuity. In this case, it is funded with a single one-time purchase payment. Other than that, it is identical to the FPDA. Single Premium Immediate Annuity (SPIA) A SPIA is funded in the same manner as a SPDA, a single one-time purchase payment, and immediately or within the first month, the policy is annuitized and the annuitant starts receiving annuity payments. Non-Qualified Annuity A non-qualified annuity is either a deferred or immediate annuity that is funded with after-tax dollars. A paycheck is the best example of after-tax dollars. A non-qualified annuity gets no special tax treatment other than being tax-deferred just like any other annuity; and, there are no contribution limitations. However, the interest earnings are still subject to the pre-59½ withdrawal penalty, but they are not subject to the required minimum distribution rules. Tax-Qualified Annuity A tax-qualified annuity is either a deferred or immediate annuity that takes advantage of some special taxing privilege found in the Internal Revenue Code. All tax-qualified annuities are funded with pre-tax dollars, usually made from an employee’s personal savings, payroll deduction or an employer’s contribution made of behalf of an employee. There are various types of tax-qualified annuities each with its own set of applicable statutes and contribution limitations. As with any annuity, the earnings grow tax-deferred; and, all money is subject to the pre-59½ withdrawal penalty and required minimum distributions rules. Since contributions to a tax-qualified annuity have never been taxed, any withdrawal or annuity payment is subject to regular income taxation. Exam CHAPTER 4: Parties to the Annuity Contract Owner The owner is any person or entity that purchases an annuity, is named in the application as owner or on record as owner in the most recent change, and has complete or shared ownership rights in the policy. An owner also includes any person or entity that succeeds to ownership as stated under any death of owner provision. If there is more than one owner, the joint owners are usually spouses and exercise ownership rights jointly. The owner may or may not be the annuitant. The owner has exclusivity in exercising the rights given by the policy. The owner may make any changes in a policy by typically sending a written request to the company in compliance with policy provisions. Prior to the maturity date and prior to a death that causes payment of a death benefit, the owner generally has the right to, but is not limited to:
Annuitant The annuitant may also be the owner and is the person on whose life the annuity benefits are based by using age and sex to determine the amount and duration of payments. There may be a secondary, or contingent, annuitant who will receive the benefits of an annuitant if the primary annuitant dies. When annuity payments begin, changing annuitants is disallowed. Upon the death of an annuitant while the owner is living, any surviving joint annuitant will become the annuitant; otherwise, it will fall on the contingent annuitant. If there is no surviving annuitant, the owner will automatically become the annuitant if the owner is an individual. If there is no surviving annuitant and there are joint owners, then the joint owners become joint annuitants. In the event that the owner is an entity and joint annuitants have been named, the joint annuitants are usually spouses. An entity can be any party of an annuity contract except annuitant. Beneficiary The beneficiary is the person(s) designated by the owner to receive death benefits in case the owner or annuitant dies before the annuity date. There may be more than one class of beneficiary, such as primary beneficiary and secondary (contingent) beneficiary. There may also be more than one person in each class. Beneficiary designations can be changed at any time by sending a request to the company in a manner prescribed in the policy provisions. If more than one beneficiary is named, each named beneficiary will share equally in any benefit or rights granted by the policy, unless indicated otherwise under the beneficiary designation or other written instructions. The beneficiary can also be an irrevocable beneficiary in whose interest cannot be changed without his consent. All rights of the beneficiary end if death occurs before the annuitant and his interests pass to the remaining beneficiaries. If the owner dies and there is no joint owner, the beneficiary may become the owner of the policy. If there are multiple beneficiaries of the same class, they may become joint owners. If settlement option payments have begun that guarantees payment for a certain period of time, the beneficiary will receive the death benefits if the annuitant dies before the expiration of the period certain. If no beneficiary is named or surviving, any death benefit will be paid to the owner or the estate(s) of the owner(s). Insurer / Insurance Company The insurer makes a contractual agreement with the owner or investor of an annuity product The insurer designs the contract to meet its needs and there is no haggling between the insurer and owner in determining the contract’s terms. Basically, the insurer allows the owner to pick the annuitant and beneficiary. In the annuity contract, the insurer defines all the rights, guarantees, benefits, restrictions and options applicable to the parties of the annuity contract: insurer, owner, annuitant and beneficiary. The insurer is responsible for investing assets for their own general account, which usually consists of investment grade corporate and U.S. Treasury bonds. Exam Investors have always been in a quandary with their investment options. On the one extreme are guaranteed or insured investments. Since these do not subject the principal to any risk of loss, the returns have always been pretty minimal with no real upside potential. When markets soar, investors kick themselves in the seat of the pants; and, when markets tank, they thank their lucky stars. On the other hand, there are the at-risk investments that attract risk takers and those who just can’t settle for mediocre returns. The tradeoff for putting principal at risk is the significant upside potential. In this case, investor reaction to the market is just the opposite of those in the first group. General Description EIAs are fixed annuities and share the same features as fixed annuities as well as some of those of at-risk investments. Most require a minimum premium of $5,000; $2,000 for qualified funds. Some are flexible pay and will accept initial and additional premiums as low as $50. The maximum age at which one can purchase an index annuity ranges from 75 to 90, depending on the policy. As with all fixed annuities, there are contractual guarantees of principal and interest. The at-risk side of the equation links interest earnings to one or more external indexes, such as the S&P 500 Index. The insurance company does not purchase any such index, but rather, they purchase options that provide a link to a particular index. The typical investment portfolio of an insurance company consists of investment grade corporate and government bonds. However, for those insurance companies that issue EIAs, options are added to the portfolio. An option basically gives the holder the right, but not the obligation, to buy the underlying security, which in this case is an external index. With that being said, other than the obvious, there are two core components that directly affect the potential yield of an EIA - interest rates and index performance.When the price of an index goes up, the price of the option that is linked to the index goes up as well. This profit is reaped by the insurance company and credits it to the EIA. Just the opposite happens when the index goes down, but the EIA is protected from any losses. There is, however, a cost to that protection in the form of fees and other limitations, most notably participation rates, asset fees and caps. For example, let’s assume an EIA’s growth is tied to the performance of the S&P 500 Index. For a given year, let’s also assume the S&P 500 Index had a gain of 20%, but the EIA had a participation rate of 80% and a cap of 12%. The participation rate represents the percentage of gain that is credited to the EIA. The cap rate is the maximum that is credited to the EIA. For our given example, this means that, per the participation rate, it could only earn 16% (20% x .8), but is further limited to only 12% because of the cap rate. It did not get any of the extra 8% growth. Our example is just a small sampling of the many combinations of crediting methods that can be used. This is one of the trade-offs between the security of investing in EIAs versus investing in at-risk investments. EIAs have an advantage over securities in that they are not considered securities and it only takes a life insurance license to sell them. Even though EIAs may have similar features of a variable product, they are not considered one. On the plus side is that once an EIA is credited with a gain, it is locked in and may not be lost to subsequent market performance. The downside is that a long-term strategy of at-risk investments will usually outperform an EIA. Of course, that doesn’t mean much if one loses 40% or more as in the 2000-02 bear market. Such a loss requires a gain of 66.67% just to reach a break-even point. Depending upon the market cycle, peak – trough – peak, regaining a break-even status could take a long time. EIAs are attractive to clients who want to participate in the upside of the market and not the downside. EIAs usually outperform certificates of deposit and other short-term interest bearing accounts, but not the stock market over the long haul. Premiums The initial premium received by the insurance company, as shown on the data page, establishes the policy or contract. If any check presented as payment of any part of the initial premium for a contract is not honored, the policy will become void. The policy owner may allocate premium payments among the various indexes then available. Premium bonus amounts, if any, are allocated to the same indexes chosen for the premium payments. The company may return any portion of a premium payment that would cause it to exceed any federal or state limitations on premium payments during any taxable year. At any time, the company may cease to accept premium payments, transfers or renewals to a specific index. In that event, any new premium payments will be allocated subject to the terms and conditions of the indexes available at that time. Whether or not the owner makes any additional premium payments, the policy will continue to be in effect until all values are distributed. Guaranteed Minimum Interest Rate The
minimum interest rate for an EIA needs to be discussed because of possible
differences from the norm. A typical fixed annuity has a minimum interest
rate guarantee on 100% of the premium that is credited annually if rates
go that low. However, an EIA is atypical in that it may not credit
interest until the end of the annuity term. In addition, the actual
crediting may be based on less than 100% of the premium, giving an
annualized rate less than the declared rate. For example, XYZ Annuity
Company has a 7-year term EIA with a minimum interest rate guarantee of 3%
on 90% of the premium, which has the effect of a 2.7% yield. There is more here than meets the eye. An EIA has several moving parts; and, it’s the way these parts are packaged that affects the bottom line – performance. One of the key aspects of an EIA is to share in market gains and not interest rate guarantees. Yet, it is those guarantees that affect gains because of the cost of providing those guarantees takes away from the purchase of options, which drives interest rates. Exam CHAPTER 6: The Indexing Function What makes the EIA a unique fixed annuity is the way in which it credits interest, which is linked to some index. There are several parts to this linking function; each serving a distinct purpose but all interrelated. THE MOVING PARTS Among the many issues concerning an insurance company, one involves setting things in motion without the option of making adjustments that could be to their detriment. No one wants their insurance carrier to have financial problems that could affect their investment, so in a way, one needs to be receptive to the non-guaranteed parts of the contract. The moving parts of an EIA determine the amount and conditions by which interest is credited to the contract. Since market conditions change, an insurance company needs to have the flexibility to change certain aspects of the contract so that they won’t cause undue financial hardship; therefore, one or more of the following are subject to change during the contract period. Participation (Par) Rate The par rate is the percentage of the change in the index that will be credited to the contract at the end of the indexing period. It is declared in advance for each premium/transfer and will not change for the related accumulated value unless that value is later transferred. For example, if the beginning index price were 975 and the ending index price were 1125, the index would have gained 150 points or 15.38%. If the par rate were 80%, then the actual crediting rate would be 12.30% (15.38 x .8). If an EIA has a 100% par rate, then the trade-off is typically a lower cap rate. If, on the other hand, an EIA has a less than 100% par rate, then the cap rate will be higher or nonexistent. Let’s assume XYZ Insurance Company offers an EIA with a 100% par rate and 10% cap as well as another EIA with a 75% par rate and 12% cap. For those EIAs that may have a 100% par rate and no caps, beware of other fees because there’s no such thing as a free lunch. Trade-offs may come in the form of certificate charges, administrative fees, service charges, management fees, asset fees, longer surrender periods and higher surrender charges. Policy provisions may reserve the right to change the par rate up or down on an annual basis. Asset Fee (Spread or Yield Spread) The asset fee is a predetermined charge against the change in the index. If the index increases by 10% percent, then a 2% asset fee would be deducted before the contract is credited the remaining 8%. However, this fee would only come into play if the index exceeds the guaranteed minimum interest rate for the same period. An asset fee is basically the same as and may be used in conjunction with the participation rate, which can exceed 100%. The creation of the asset fee was just a marketing redesign of the participation rate. Let’s say Green Acres EIA has a 1% asset fee. If the index increases 10%, the contract will be credited with 9%:
This
is the same as having no asset fee and a 90% participation rate:
As you can see, at a 10% index gain, every 1% of asset fee is the same equivalent as a 10% reduction in the participation rate. However, the equality stops there. For an index gain of less than 10%, the asset fee has a greater percentage impact; and, for gains greater than 10%, its percentage impact is less. Let’s use the previous example for our next illustration. If we had a beginning index price of 975 and ending index price of 1125, the index gained 150 points or 15.38%. If the asset fee were 4%, then the actual crediting rate would be 11.38%. Asset fees are only applicable when the index is in positive territory and surpasses any interest guarantees. They are typically not used in conjunction with caps and the policy provisions determine asset fee increases, maximum rates and guarantees. Asset fees are always applicable whereas caps are not. The higher the cap, the less it comes into play. Since the asset fee is contractually flexible, one should carefully inspect the terms of the policy to determine its future impact. Cap Rate The cap rate is the maximum interest an EIA can earn during a specific term period. Since a cap limits the upside, then one can expect a more favorable participation rate and asset fee (if applicable). Generally, the higher the participation rate, the lower the cap and vice versa. A Cap can either be applied to the index (Index Cap) increase before adjustments are made for participation rate or asset fee; or, they can be applied after the participation rate or asset fee (Interest Cap). If an EIA has a 10% Index Cap and the index that it is linked to goes up 15.38%, then the contract only gets credited with 10% before the participation rate is applied. On the other hand, if an EIA has a 10% Interest Cap and the index goes up 15.38%, the participation rate is applied then the result is compared to the cap rate. The lesser of the two is the amount that is credited. Let’s look at another scenario. We have two EIAs, one with a cap rate of 8% with a 100% par rate and the other with no cap and a 65% par rate. At what interest rate will an investor be indifferent? The answer is 12.31% (.08 / .65). If the Index gains more than 12.31%, then the no cap EIA will be better. If the Index gains less than 12.31%, then the 8% cap EIA will be better. One would have to look at the historical returns for the linked-to Index to see if a capped product or non-capped product would be best. Of course, since past track record is never indicative of future performance, this may be a useless venture. Nevertheless, it may give one some basis for making a decision. The higher the cap, the lesser the chance that the cap will play a significant role in minimizing gains, but serves more as a security blanket for the insurance company. Since insurance companies do not advertise which type of cap they use, a properly deciphered illustration can do the trick. FEATURES Index The index means the measure used for determining the index value and credits. Unlike other investments, indexes do not reflect the reinvestment of dividends. Depending upon one’s perspective, this may not be an attractive sales feature. All mutual funds show the extent of their growth based on the reinvestment of dividends; and, for some funds, this is quite extensive. If the index is discontinued or if the calculation of the index is substantially changed, the insurance company may substitute an alternative index, subject to approval by the state insurance department of the state in which the policy is issued. Following are some of the more popular indexes, which are listed with the Chicago Board Options Exchange (CBOE). Standard & Poor’s 500 Index (CBOE Symbol: SPX) - an unmanaged index that represents 500 of the largest and well known publicly held companies in the United States. It is also used as a benchmark for investment performance. All investors want to know how well their investments perform, so in order to determine that, performance needs to be measured against something that is widely accepted as the standard, which is typically the S&P 500 Index. Nasdaq 100 Index (CBOE Symbol: NDX) - represents 100 of the largest domestic and international non-financial companies listed on the NASDAQ, based on market capitalization. It does not include any financial or investment companies. Dow Jones Industrial Average Index (CBOE Symbol: DJX) - an unmanaged price-weighted index of 30 industrial stocks from the New York Stock Exchange and Nasdaq. Like the S&P 500 Index, it is a recognized performance barometer for U.S. equities. Russell 2000 Index (CBOE Symbol: RUT) - a small-cap barometer of U.S. equities. It consists of the smallest 2000 companies in the Russell 3000 Index, which comprises the largest 3000 companies in the U.S. market. Shearson Lehman Bond Index - also known as the Shearson Lehman Government/Corporate Bond Index. This index is composed of approximately 5,000 publicly issued U.S. government and corporate bonds rated Baa or better. It is weighted by the market value of the bonds in the index and the rate of return reflects the total return including reinvested interest. U.S. Treasury Index - the yield credited to the contract is based on the performance of 10-year U.S. Treasury Bonds. Corporate Bond Index - the yield credited is based on a portfolio of investment grade corporate bonds. In reality, an index can be anything so long as the insurance company can link to it directly, such as the Consumer Price Index, or indirectly via some feature having “linking” properties, such as an index option is to an index (SPX option > SPX). Index Credit This is the amount earned by each premium/transfer based on the increase in the index. It is the greater of (1) or (2) where:
Indexing Period The indexing period means the period over which the index yield is calculated. Each premium/transfer has an indexing period associated with it. The initial indexing period begins upon the receipt of the initial premium/transfer. Subsequent indexing periods begin immediately following the end of the prior indexing period. Index Price This is the published value of an index. Each premium/transfer in an index will be assigned an index price that will be the index price as of the close of business on the day before the premium/transfer is received. The index price for the start of each indexing period after the first will be the index price as of the close of business on the day before the premium/transfer anniversary. If the index price is not published on any day for which a calculation is made, the first preceding published index price will be used. Point-to-Point This refers to a specific time frame to determine the crediting rate. The beginning point is the index price at the start of the period and the ending point is the index price at the end of the period. For example, let’s consider an EIA using the Capital Stock Index and an annual point-to-point. The beginning index price is 975 and the ending price, one year later, is 1125. The gain of 15.38% ((1125-975)/975) is credited to the contract and the process starts all over again with a beginning index price of 1125. This crediting at the end of the period and starting anew is referred to as ‘annual reset.’ The point-to-point time period can also be longer or shorter than one year. A term longer than one year - ‘term point-to-point’ or ‘long-term point-to-point - performs best when the market trend is upward. Long-Term Point-to-Point (LT P2P) Also known as Term Point-to-Point and Term End Point, it is one with a term period longer than one year, usually five or more. Let’s consider a seven-year LT P2P. The beginning price for the Capital Stock Index was 975 and its ending price, seven years later was 1550. This results in an index credit of 58.97% ((1550-975)/975). In actual practice, the ending price (1550) is rarely used but rather some sort of averaging for the last year. This is also the only indexing method whereby the moving parts don’t move in the interim. This could be an advantage where market performance results in declining participation rates, but disadvantageous when participation rates rise. A couple of things come to mind when dealing with a crediting period different from the normal annuity: premature death and surrender before the end of the crediting period. What happens to the index appreciation if one dies before the end of the indexing term? There are typically three options. The first is that death benefits will follow the same pattern as any other fixed annuity and pay an amount equal to the account value plus a minimum rate of return. The second is to substitute the last policy anniversary for the maturity date. Lastly, the date of death will substitute as the maturity date, accrued index gains will be credited and surrender charges waived. What happens to the index appreciation if one surrenders the policy before the end of the indexing period? Since Term Point-to-Point annuities don’t credit gains until the end of the indexing period, there would be no interest credited from the indexing function of the policy. There is no annualized crediting of appreciation in the index. If there were any gains, they would come from the minimum interest guarantees of the policy. High Water Mark Also known as Term High Point, it is the same as the Long Term Point-to-Point with one major difference. The ending index value is not necessarily the one at the end of the term, but the highest index value on any policy anniversary during the term of the policy. If the Capital Stock Index started at 975 and ended at 1550 seven years later, normal indexing would make 1550 the ending index value. However, the highest index value was 1600 at the end of the sixth year (year 7). This will result in an index gain of 64.10% ((1600-975)/975) instead of 58.97%. Since the High Water Mark method of indexing provides for the maximum gain possible and protects against market declines in the latter stages of the annuity term, one may wonder why any other method is considered. Well, it comes back to the old saying that there’s no free lunch. It naturally costs more for this indexing method, so there is a tradeoff in lower caps and participation rates. Low Water Mark Low Water Mark is just the opposite of High Water Mark. In our example above, Capital Stock Index began at 975; however, it had dropped down to 940 one year later. Using this indexing method means that the starting index price will be 940 instead of 975. Annual Reset Annual Reset refers to the index starting anew after an indexing period has ended and the gain credited to the contract. For example, an annual point-to-point EIA has a beginning index price of 975 and ending price, one year later, of 1125. The gain of 15.38% is credited to the contract, the process starts all over again and the beginning index price is reset at 1125. This method of locking in gains neutralizes future losses as compared to other investment alternatives such as a mutual fund. Let’s consider the above EIA whereby the index price in the second year went from 1125 to 825. Since an EIA with the annual reset feature has a built-in 0% loss guarantee, it would average 7.69% (15.38 / 2) over those 2 years. By assuming the same beginning and ending index prices, a mutual fund would average a 7.69% loss over those 2 years. Using this analogy, one can conclude that the annual reset is beneficial during volatile markets. Let’s summarize the impact of the Annual Reset feature by comparing the results of investing $10,000 in the Capital Stock Index with an EIA having a 50% par rate. As a reminder, the price of an index and index option rises and falls creating gains and losses. However, since an EIA can only post a zero gain when the index is in negative territory, its value remains the same during negative years. Per our example above, the results are that the Index has an annualized yield of 6.85% and the EIA is 5.69%. That’s not a whole lot of difference considering the differences in the risk between the two. If the EIA had a 60.70% par rate instead of 50%, the value of both at the end of the seven years would be identical. Averaging This is basically a short version of the annual point-to-point by using a series of shorter points during an indexing period, which may be monthly, weekly or daily. For example, let’s consider monthly averaging, which uses a monthly point-to-point based on the monthly anniversary date. Each monthly index price is added together and the total is divided by 12 to give an average ending index price. From there, one can calculate the gain/loss. The benefits of averaging run along the same lines as dollar-cost-averaging. It works best during volatile markets and smoothes out the rough spots but will hinder growth during bullish trends. Averaging always brings performance to some sort of middle ground. In rising markets, averaging will result in about one-half of the index gain; and, in decreasing markets, averaging will result in about one-half of the index loss. Because of this, averaging products are usually coupled with lower Asset Fees and higher Caps and Par Rates. WHAT AFFECTS PERFORMANCE AND PARTICIPATION RATES? Why do EIAs differ in providing guarantees? Well, this gives insurers more flexibility in buying index options so that the policy will rely more on index performance than minimum interest guarantees – more upside potential and little or no gain on the downside. In order for an insurance company to guarantee a minimum interest rate every year, it costs money, money that could be used for the purchase of index options. Let’s see how this would play out. There are two things that take precedence before an insurance company can buy options. First, it must be able to cover its own expenses; and, second, it must be able to meet its guarantees. An insurance company is no different from any other company in that the cost of doing business must be transferred to the products they sell. For example, High Noon Annuity Company has fixed expenses and variable expenses. Its fixed expenses are from maintaining their administrative offices, salaries, utilities, insurance, depreciation, etc. They also have variable expenses such as agent commissions from selling annuities. Corporate profit would be included in the picture as well. All of these must be passed on to the consumer and recouped in the way they price their products. The actuaries at High Noon have determined that for every $1.00 in annuity premium they receive, $0.10 goes out in the form of fixed and variable expenses and profit. Next, High Noon guarantees that their 7-year term EIA will earn 3% on 90% of the principal when the annuity matures in 7 years. Well, what is the future value of $1.00 at 3% in 7 years? To figure this, one can either go to a future value interest table or use a financial function calculator. The formula is $1.00 * 1.037, which equals $1.23. In common language, this means that if $1.00 earned 3% for 7 years, it would be worth $1.23. However, in this example, the insurance company is only guaranteeing 90% of that dollar; therefore, we would multiply $1.23 by .90, which equals $1.107. For simplification purposes, we’ll round this up to $1.11. From this we know that the insurance company must have $1.11 available in 7 years for every dollar it collects today. Since it is probably going to invest in bonds, we need to find out how much will have to be spent on bonds today to be worth $1.11 in 7 years. Assuming a current yield for 7-year bonds is 5%, we’ll use a financial function calculator to find our answer: 5[%], 1.11[FV], 7[N], CPT[PV] = $0.79. Again, in common terms, it takes seventy-nine cents invested at 5% for 7 years to equal $1.11. Here’s a summary:
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