Equity Indexed Annuity (EIA) or Fixed Indexed Annuities (FIA) are a type of Annuities that offers Annuitant an opportunity to earn “market-like” returns while protecting from any downside.
Does an equity-indexed annuity offer investors both principal protection and high capital appreciation at the same time?
“Participation in stock market’s upside with downside protection when it falls.” This is a general pitch made by the sales agents. New investors or people who have lost money during recessions have hesitation to directly invest in equities; find the sales pitch very attractive.
Equity-indexed annuities (EIA) are a good option where the downside risk is reduced. EIA provides fixed-income stability and superior growth as compared to traditional fixed-income products. However, investing in EIA comes with a substantial opportunity cost as it provides significantly lower returns as compared to the actual market returns. The funds invested in EIA acts like Treasury bill investment with low volatility and low returns compared to investments with long-run returns.
What is an Equity‐Indexed Annuity?
An annuity is an investment contract, used for retirement purposes, with an insurance company. There are primarily two types of annuities: Fixed annuity and Variable annuity
Fixed annuities are investment contracts where the interest rate doesn’t change from the percentage set in the contract at the time of purchase. Thus, the values are guaranteed to increase at a fixed rate. Whereas, for variable annuities, the investment returns change according to the performance of the investment portfolio. The upside of a variable annuity is an opportunity for greater returns, but the flip side is a risk of less growth of the underlying portfolio.
Equity Index Annuities (EIA) is a combination or hybrid of the fixed and variable annuity. The interest paid on EIA is paid in two parts. One part of the interest rate earned is a guaranteed minimum, which ranges from 1% to 3% on the premium paid and the other part is linked to the specified equities index.
The EIA offers slightly higher returns than fixed-rate annuities, but lower than variable-rate annuities, but with better downside risk protection than variable annuities usually offer.
Features of equity-indexed annuities
Return linked with Market Indexes:
The returns on an EIA are mostly based on a market index, such as the S&P 500 index. EIA contracts specify that return on an annuity is determined based on capital or price appreciation only, excluding dividends. However, excluding dividends from the index causes investors to miss out on a big portion of equity returns.
The index credited to the annuity is determined based on the participation rate. The participation rate generally ranges from 80%-100%.
For instance, if the participation rate is set at 90% by the insurance company and S&P 500 rises by 10% in a given period, then 9% (i.e. 90% of gain) will be credited to the EIA account.
Cap on upside potential
Many insurance companies put a cap on the return over a certain period of time. For example, if the index return is around 8% and the cap placed by the company is at 3%, then the investor will receive only a 3% rate of return.
In a study done over a period of 480 months, the 3% monthly cap was placed 151 times or 1/3rd of the months. During this period, the reduction in the rate of return exceeded more than 9% in 9 of these months and 5% in 20 of the months. Such reductions have a significant impact on the growth rate of the annuity.
Downside protection is the most preferred feature by conservative investors. EIA contracts include a minimum annual index-linked return. For instance, if the S&P 500 declines by 7% over a year, still the index-linked return earned by the policyholder will be 0 and not negative.
Guaranteed Minimum Return
The guaranteed minimum return is the most attractive feature of the EIA. State insurance laws prefer to be assured with a guaranteed minimum return applied to the premium. The widely accepted guaranteed minimum rate of return on EIA contracts is ~1-3% on 90% of the value of the premium paid. The guaranteed minimum rate is computed only on the original premium paid and doesn’t consider subsequent returns credited to the account.
The downside protection is additionally applied to index-linked returns and guaranteed minimum returns, credited to an account at the end of each policy year. This provision ‘locks in’ any previously credited premium or returns.
Spread, Margin, or Asset Fee
Spread, Margin, or Asset Fee is a major caveat that consumes the return earning potential. Many EIAs include spread fees as an annual percentage charge which is subtracted from the return of the annuity.
Limitations of Equity-Indexed Annuities
Surrender fee is a significant clause to loof after while buying an EIA. A surrender fee is charged if the policyholder needs to access the funds before the specified surrender period in the contract. Surrender fees vary with policies. Also, the insurance agents get sizable commissions sometimes higher than other types of annuities.
Index Annuity Pros and Cons
EIAs are not exceptional. They have their benefits and costs, even with their hybrid nature. EIAs have a mixed utility. They have the potential for slightly higher returns without severe risks. These annuities are relatively complex products and thus are difficult to understand.
- Like other types of annuities, the indexed annuities are tax-deferred product.
- As returns are linked to index performance, the increase in index increases the value of the contract.
- The loss due to the stock market underperformance is limited.
- Provide better rates than traditional instruments like certificate of deposit.
- Cap on returns
- Higher fees and expenses reduce the actual gains.
- Lack of fee transparency, fees may not be clearly disclosed.
- Like other types of annuities, you may face high surrender charges for early withdrawal.
The prominent question remains whether the reduced volatile nature of the products is worth the price paid for lower returns. Investors interested in EIA should recognize that these products are better characterized than equity investments.
While they do have the potential to capture some of the stock index returns, the caps, participation rates, and other moving parts severely limit that benefit.
As one analyst has put it in a funny way, “The upside to an equity‐indexed annuity is that there is no downside. The downside to an equity‐indexed annuity is that there is very limited upside.”
A study shows, a 40‐year compounded annual growth rate of equity-linked annuities (6.5%) which is significantly lower than the S&P 500 (11%) and only marginally higher than T‐bills(5.2%), investors might consider the EIA along with other fixed investment alternatives, but not in the same league with equity investments.