Why Equity Indexed Annuities Work

The Way They Do

Equity Indexed Annuities are here to stay. While they may seem complicated at first, they are really just annuities that credit money to the clients balance a little differently than the ordinary deferred annuity.

This article provides a look at the concepts behind designing an Equity Indexed Annuity–how and why an EIA works the way it does, along with the trade-offs that are necessary from both a Marketing and Financial point of view.

EIAs are products that provide stock market linked returns with little or no risk of loss due to a decline in the index. Thats the exciting part, the “no risk of loss” due to the decline in the index. Weve seen a decade of great stock market returns in the 90s reduced dramatically by 3 years of significant losses. What if we didnt have to recognize those losses and kept a good portion of the gains? How much more money would we have? Theres no magic formula here to give us that answer. But EIAs can provide good returns and still be a safe investment for retirees.

So, how do these products really work? First lets look at the investments behind these products. Not all companies are the same, but this is a typical investment strategy. Most of the premium received by the company is invested in bonds just like a regular annuity. This provides for the minimum guarantee fund found in most EIAs.

But a small portion of the premium is invested in stock market options, (and in some cases more advanced derivative instruments). Typically, its best to use an option that has been custom designed to match the exact index and anniversary dates of the annuity premiums. These options will pay off if the stock market goes up, and this provides the funds to pay the policyholder their “interest.” If the stock market goes down, then the options expire worthless and no interest is credited to the policy. Then we start the option process over for the next period. Most products are annual reset, so this process is renewed each year.

Question: How much of the gain can the client expect to receive as the index moves up and still not have to take any of the losses when it declines?

Answer: Theres no way consistently to get all of the gain with none of the losses. Theres no free ride. If there was, we could all just sit around and collect our gains with no worry of losses. But most of the time you can get a good part (typically 50%-70%) of the gains, with none of the losses. It depends on the design of the particular product and the movement of the index. With monthly or daily average options, there can be instances where none of the gain is credited, or more than 100% of the gain is credited for a given period. It depends on the design and the movement of the index.

Question: Why are there so many variations of caps, fees, monthly or daily averaging or participation rates other than 100%?

Answer: Caps, fees, averaging and participation rates are a way of reducing the cost of options. Only a certain amount of the annuity fund is available for the purchase of options. And, option costs can vary quite a bit as the stock market changes. So, caps, fees and participation rates are set with two goals in mind: first, reduce the cost of the option to the amount available to spend; and second, pick the caps, fees and participation rates that are most likely to get the client the best return.

If the index gain is relatively low, then products with a low fee will have the best payoff. If the index gain is relatively high, then a little bigger fee is OK, but a high cap is important. Of course, every company issuing these products has a little different opinion about which will pay off best.

Question: Why do some companies accept premiums only on certain dates?

Answer: Accepting premium on any day of the week involves two potential problems: 1) An investment in the administration system to track all the data is needed. The reporting of the results will be a little more complicated, since you will have some premium buckets that are not able to be calculated because the term of the option is not yet over; and 2) The company will have some additional risk if it does not have the daily sales volume to make it worthwhile to buy options each day.