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Life Health > Annuities

Why Equity Indexed Annuities Work

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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.

EIA products that are able to accept premium every day the stock market is open will have an advantage. The client can make other investments any day of the week. If EIAs are expected to be a true competitor, they should be available every day also.

Question: Is the term of the EIA important? Are annual reset products better than longer-term products?

Answer: Annual reset EIAs lock in the gains each year so that future declines in the market dont affect past returns. This is a valuable feature in a zig-zag market. In longer-term products, bad years erase past gains. However, longer-term products sometimes can offer higher participation rates and may pay off better if the index goes up steadily for the entire term.

Most companies currently seem to be favoring the Annual Reset design because of the ability to lock in gains on an annual basis.

Question: Does the index matter? Are there advantages to using the S&P over the DJIA, or Nasdaq 100?

Answer: Each index represents a slightly different segment of the market. However, there is a pretty strong correlation between them. Any of them may outperform the others during a given period. The S&P is the most common for a few reasons: A) It is very widely recognized by the general public; B) It is a broader index, so the movement of one stock or market segment will have less effect (positive or negative) on the index; and, C) Options are a little more readily available on the S&P, and are sometimes a little cheaper than other indexes.

There is another factor for most companies. Economies of scale can be realized if fewer indexes are used. These options are purchased from investment banks that dont like small transactions. Its more difficult to hedge a small position in an index. So having all the money focused in one index works best.

Question: Are all fees and caps defined the same?

Answer: Not necessarily. Some caps include a fee and others dont. You should know which way the products cap would work. Following the rule that simple is the best, we would like to see all caps be the true limit of what the policyholder can have credited to his or her annuity.

In summary, an Equity Indexed Annuity is a good product to provide the enhanced returns of the stock market with no risk of loss of principal due to changes in the index. Expectations should be realistic. In some years, the return wont be that good. But over the long term, EIAs could provide a higher return than most interest rate-based annuities.

Stephen Wilson, ASA, MAAA, FLMI, CLU, CHFC, is
Assistant Vice President and Product Actuary at
Standard Life Insurance Company of Indiana. He can be reached via e-mail at [email protected].

Michael A. Quaranta is
Senior Vice President and Chief Marketing Officer at
Standard Life Insurance Company of Indiana. He can be reached at [email protected].

Reproduced from National Underwriter Life & Health/Financial Services Edition, February 13, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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