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Why an
Alert on Equity-Indexed Annuities?
Sales of
equity-indexed annuities (EIAs) have
grown considerably in recent years. Although one insurance company
includes the word "simple" in the name of their product, EIAs are
anything but easy to understand. One of the most confusing features of
an EIA is the method used to calculate the gain in the index to which
the annuity is linked. To make matters worse, there is not one, but
several different indexing methods. Because of the variety and
complexity of the methods used to credit interest, investors will find
it difficult to compare one EIA to another.
Before you buy an EIA, you
should understand the various features of this investment and be
prepared to ask your insurance agent, broker, financial planner, or
other financial professional lots of questions about whether an EIA is
right for you.
What is an Annuity?
An annuity is a contract between you and an insurance company in which
the company promises to make periodic payments to you, starting
immediately or at some future time. If the payments are delayed to the
future, you have a deferred annuity.
If the payments start immediately, you have an
immediate annuity. You buy the annuity either with a single
payment or a series of payments called premiums.
Annuities come in two
types: fixed and variable. With a fixed annuity,
the insurance company guarantees both the rate of return and the payout.
As its name implies, a variable annuity's
rate of return is not stable, but varies with the stock, bond, and money
market funds that you choose as investment options. There is no
guarantee that you will earn any return on your investment and there is
a risk that you will lose money. Unlike fixed contracts, variable
annuities are securities registered with the Securities and Exchange
Commission (SEC). To learn more about variable annuities, read our
Investor Alert,
Should You Exchange Your
Variable Annuity?
What is an Equity-Indexed Annuity?
EIAs have characteristics of both fixed and variable annuities. Their
return varies more than a fixed annuity, but not as much as a variable
annuity. So EIAs give you more risk (but more potential return) than a
fixed annuity but less risk (and less potential return) than a variable
annuity.
EIAs offer a minimum
guaranteed interest rate combined with an interest rate linked to a
market index. Because of the guaranteed interest rate, EIAs have less
market risk than variable annuities. EIAs also have the potential to
earn returns better than traditional fixed annuities when the stock
market is rising.
What is the Guaranteed Minimum Return?
The guaranteed minimum
return for an EIA is typically 90% of the premium paid at a 3% annual
interest rate. However, if you surrender your EIA early, you may have to
pay a significant surrender charge and a 10% tax penalty that will
reduce or eliminate any return.
How good is this guarantee?
Your guaranteed return
is only as good as the insurance company that gives it. While it is not
a common occurrence that a life insurance company is unable to meet its
obligations, it happens. There are several private companies that rate
an insurance company's financial strength. Information about these firms
can be found on the
New Jersey Department of Banking & Insurance's Web site.
What is a market index?
A market index tracks
the performance of a specific group of stocks representing a particular
segment of the market, or in some cases an entire market. For example,
the S&P 500 Composite Stock Price Index is an index of 500 stocks
intended to be representative of a broad segment of the market. There
are indexes for almost every conceivable sector of the stock market.
Most EIAs are based on the S&P 500, but other indexes also are used.
Some EIAs even allow investors to select one or more indexes.
How is an EIA's index-linked interest rate computed?
The index-linked gain depends on the particular combination of indexing
features that an EIA uses. The most common indexing features are listed
below. To fully understand an EIA, make sure you not only understand
each feature, but also how the features work together since these
features can dramatically impact the return on your investment.
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Participation Rates. A participation rate determines
how much of the gain in the index will be credited to the annuity.
For example, the insurance company may set the participation rate at
80%, which means the annuity would only be credited with 80% of the
gain experienced by the index.
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Spread/Margin/Asset Fee. Some EIAs use a spread,
margin or asset fee in addition to, or instead of, a participation
rate. This percentage will be subtracted from any gain in the index
linked to the annuity. For example, if the index gained 10% and the
spread/margin/asset fee is 3.5%, then the gain in the annuity would
be only 6.5%.
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Interest Rate Caps. Some EIAs may put a cap or upper
limit on your return. This cap rate is generally stated as a
percentage. This is the maximum rate of interest the annuity will
earn. For example, if the index linked to the annuity gained 10% and
the cap rate was 8%, then the gain in the annuity would be 8%.
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Caution! Some EIAs allow the
insurance company to change participation rates, cap rates, or
spread/asset/margin fees either annually or at the start of the
next contract term. If an insurance company subsequently lowers
the participation rate or cap rate or increases the
spread/asset/margin fees, this could adversely affect your
return. Read your contract carefully to see if it allows the
insurance company to change these features. |
Indexing Methods. As described in the
table below, there are several methods for determining the change in the
relevant index over the period of the annuity. These varying methods
impact the calculation of the amount of interest to be credited to the
contract based on a change in the index.
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Indexing Method |
Description |
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Annual Reset (Rachet) |
Compares
the change in the index from the beginning to the
end of each year. Any declines are ignored.
Advantage: Your
gain is "locked in" each year.
Disadvantage:
Can be combined with other features, such as lower
cap rates and participation rates that will limit
the amount of interest you might gain each year.
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High Water Mark |
Looks at
the index value at various points during the
contract, usually annual anniversaries. It then
takes the highest of these values and compares it to
the index level at the start of the term.
Advantage: May
credit you with more interest than other indexing
methods and protect against declines in the index.
Disadvantage:
Because interest is not credited until the end of
the term, you may not receive any index-link gain if
you surrender your EIA early. It can also be
combined with other features; such as lower cap
rates and participation rates that will limit the
amount of interest you might gain each year.
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Point-to-Point |
Compares
the change in the index at two discrete points in
time, such as the beginning and ending dates of the
contract term.
Advantage: May
be combined with other features, such as higher cap
and participation rates, that may credit you with
more interest.
Disadvantage:
Relies on single point in time to calculate
interest. Therefore, even if the index that your
annuity is linked to is going up throughout the term
of your investment, if it declines dramatically on
the last day of the term, then part or all of the
earlier gain can be lost. Because interest is not
credited until the end of the term, you may not
receive any index-link gain if you surrender your
EIA early. |
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Can I get my money when I need it?
EIAs are long-term investments. Getting out early may mean taking a
loss. Many EIAs have surrender charges. The surrender charge can be a
percentage of the amount withdrawn or a reduction in the interest rate
credited to the EIA.
Also, any withdrawals from tax-deferred annuities before you reach
the age of 59½ are generally subject to a 10% tax penalty in addition to
any gain being taxed as ordinary income.
Do EIAs and other tax-deferred
annuities provide the same advantages as 401(k)s and other before tax
retirement plans?
No, 401(k) plans and other before-tax retirement savings plans not
only allow you to defer taxes on income and investment gains, but your
contributions reduce your current taxable income. That's why most
investors should consider an EIA and other annuity products only after
they make the maximum contribution to their 401(k) and other before-tax
retirement plans. To learn more about 401(k)s, please read
Smart 401(k) Investing.
Is it possible to lose money in an EIA?
Yes. Many insurance companies only guarantee that you'll receive 90%
of the premiums you paid, plus at least 3% interest. Therefore, if you
don't receive any index-linked interest, you could lose money on your
investment. One way that you could not receive any index-linked interest
is if the index linked to your annuity declines. The other way you may
not receive any index-linked interest is if you surrender your EIA
before maturity. Some insurance companies will not credit you with
index-linked interest when you surrender your annuity early.
If You Have Questions
If you have questions about EIAs, you can contact your
state insurance commissioner. You can check out whether the person
selling an EIA is registered with the NASD check
NASD BrokerCheck or contact us for
help.
Contact
Information
- Telephone
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(602)485-3896
- Postal address
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13835 N. Tatum Blvd. Ste. 9-422 Phoenix, AZ 85032
- Electronic mail
- General Information:
info@azmythfinancial.com
Sales:
sales@azmythfinancial.com
Customer Support:
support@azmythfinancial.com
Media Inquiries:
pr@azmythfinancial.com
- Webmaster:
web@azmythfinancial.com
- Other
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Progressive Prosperity Blog
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