Equity Indexed Annuities Made Clear

Equity indexed annuities are investment contracts between insurance companies and individuals. The investment returns on these contracts are closely tied to returns on an index of equity (stock) prices. The most popular index employed by equity indexed annuities is the Standard & Poor‘s 500 index of stock prices. Assuming, as is the case with the S&P 500, that the index itself is tradable, the investor could buy index contracts directly or (more awkwardly) buy the underlying stocks in the contract individually. Understanding why many investors choose the annuity alternative instead helps us to understand the workings of equity indexed annuities.

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The Stock Index

An index of stock prices averages those prices in order to capture their central tendency. Exchanges began selling stock-index contracts to allow investors to own a portfolio representing a broad average of stock-market performance without incurring the expense of separately purchasing the individual stocks. The dominant academic theory of stock-price movements, the random-walk theory, denies that investors can systematically predict future stock prices. Portfolio managers whose returns beat the market averages are lucky rather than skillful. Rather than actively managing their portfolios, investors should passively settle for an average market return – the best that can consistently be achieved. This will save vast investigative effort and forestall potential disaster associated with unfortunate portfolio choices. By eliminating trading, it keeps management costs to a bare minimum.

Advantages of Equity Indexed Annuities

Equity indexed annuities link the investor’s return to the return on a stock index, as does a contract on that same index. The annuity format offers certain advantages not available to buyers of stock-index contracts. One advantage is tax deferral. Deferred annuity gains accumulate and compound tax-free; not until distribution are gains taxed as ordinary income. The larger the rate of tax avoided prior to retirement (during deferral) compared to the rate paid during retirement, the greater is the gain from deferral.

A second type of gain stems from the guarantees and protections enjoyed by equity indexed annuities, which are representative of those associated with annuities in general. Like other annuities, equity indexed annuities are retirement-oriented investment vehicles. Withdrawals by holders younger than age 59 ½ are subject to a 10% penalty levied by the IRS. The issuing insurance company will exact surrender charges on early withdrawals. Special precautions to insure a positive return on retirement savings are justified by the fact that the annuity holder will not earn income during retirement and will depend entirely on savings. This causes issuing insurance companies to include provisions in equity indexed annuity contracts that place a floor under the credited interest rate and income even during market downturns.

Additional provisions in the annuity contract act as buffers to limit variations in index values. The participation rate stipulates the percentage of the variation in index changes that figures in the return credited to annuity holders. A participation rate of 90%, for example, would credit annuity holders with a 9% gain when the index rises by 10%. (The participation rate can normally be changed by the insurance company from year to year, but the contract stipulates the upper and lower bounds of the rate, with the lower bound being no lower than zero.) The contract also stipulates which of various possible formulas will determine the change in the index itself over time. Among the possibilities are the point-to-point method, which calculates the rate of change between index values on specific dates; the high-water-mark method, which accepts the highest index value since the last valuation date for calculation purposes; the annual reset method, which tries to offset extreme market movements by resetting the index annually for interest-crediting purposes; and annual averaging methods, which average index values over the course of the valuation year.

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The Insurance Element of Equity Indexed Annuities

The list of features designed to protect investor principal and limit rate-of-return fluctuations distinguishes annuity investment from other forms. They are the insurance element of the annuity investment contract. Each of these features offers potential benefits to risk-averse investors who want to benefit from the equity indexation concept while reducing downside investment risk. That risk reduction carries a cost – the extra expense incurred with the creation of each insurance feature. Those investors who deem the insurance worth the extra cost will purchase equity indexed annuities.  In fact, they have been extremely popular since their debut in the 1990s.

The Risk Profile of Equity Indexed Annuity Buyers

Another way to place investment in equity indexed annuities in perspective is by comparing it with alternative annuity investments. Fixed annuities are tantamount to fixed-income investment (with annuity insurance features added), while variable annuities are equivalent to active investing in mutual funds or bond funds (again, with annuity insurance features added). Equity indexed annuities allow people who prefer passive investing and are willing to settle for an average equity-market return to satisfy their preferences while enjoying the insurance protections provided by annuities. Thus, the risk profile of suitable investors in equity indexed annuities pinpoints them as more risk-tolerant than fixed-annuity investors but significantly less so than variable-annuity investors. Investors approaching retirement or new retirees are good candidates for equity indexed annuities.

Increases in life expectancy and the ever-present threat of inflation on fixed incomes have combined to make equity investment relatively more attractive to retirees. Equity indexed annuities provide a way for retirees to have it both ways – participate in the higher returns of equity markets without running all of the risk of unhedged stock-market investment. Annuities provide a limited amount of liquidity (typically, 10% or annual interest in penalty-free withdrawals) and often include provisions waiving surrender charges in special circumstances, such as medical emergency or financial exigency. Still, liquidity limitations make all annuities a questionable purchase decision for the truly aged.

Regulation of Equity Indexed Annuities

The regulation of annuities is subject to the provisions of the Securities Act of 1933, which created a “safe harbor exemption” from securities regulation for insurance products. In order to meet the exemption, the insurance products had to submit to state regulation, advertise in a restrained manner and desist from assigning investment risk to consumers. Until recently, few equity indexed annuities were deemed to be securities. However, a January, 2009, ruling by the Securities and Exchange Commission declared that after January, 2011, all indexed annuity products would be deemed to be securities and required to issue prospectuses to buyers.

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