Not All Indeed Annuities Are Created Equal

Quick: Name the barely decade-old investment that consumers are pouring roughly $24 billion into each year.

Would you be surprised to learn the answer is the equity indexed annuity (EIA)? Also called an index annuity, this special fixed annuity has been touted as an alternative to both a bank certificate of deposit and a stock market investment.

Consumers are responding in a big way, because the EIA offers a share of stock market-linked gains without any stock market losses.

But advisors beware: With an EIA, the devil is in the details. Different ones can produce different rates of return for the investor. Here’s why.

To participate in the market without having to buy stocks, the issuing insurer buys call options on stock market indexes, such as the S&P 500. Options for EIAs are unique to the marketplace. They are constructed so as to pass returns to the purchaser that emulate the ownership of the underlying security with very little impact of traditional market forces.

The way these option contracts are structured results in an “index crediting method.” Most EIA index crediting methods are created by organizations that market insurance products to agents–so-called insurance marketing organizations. They know what product designs attract consumers.

The prices of option contracts are most influenced by term of the contract and volatility of the underlying index. The contract type determines the EIA’s crediting method, participation rate, spread/asset fee and cap.

Certain crediting methods can constrain the potential gain for an investor in the EIA. For example, a “monthly averaging” method has less volatile returns than a “point to point” method, which credits index-linked interest based on the increase in index value from the beginning to the end of the month or the year. All other things being equal, the premium the insurers pay for the option in the point-to-point contract is higher. (You can’t gain in one area without losing somewhere else.)

Current EIA products that use point-to-point crediting methods have a lower cap (maximum credited interest allowed) than those using monthly averaging.

Although EIAs are not securities and have no principal risk, they do have a risk of return distributions. Index-credit methods offer returns to the policyholder only when the index credit method is positive. (Though some EIA products offer guarantees for minimum annual returns, most offer minimum returns over the life of the contract).

Let’s take a look at past performance of various index-crediting methods vs. the performance of the S&P 500. Since the EIA is primarily designed to protect the contract owner from loss of principal, we’ll start with a bear market example and then show an example based on recent history. (See Tables 1 and 2.)