EQUITY-INDEXED ANNUITIES

Transcription

1 Understanding EQUITY-INDEXED ANNUITIES 1997 Pictorial, Inc. Indianapolis, IN fax: PRINTED IN U.S.A.

2 This booklet was designed to provide a general explanation of this topic. We do not represent that the content is a complete discussion of the subject. We have tried to provide you with the most accurate and useful information possible. However, the content of this publication may be affected by changes in law or industry practices, and as a result, information contained in this publication may become outdated. This material should in no way be used as an original source of authority on legal matters. 2

3 TABLE OF CONTENTS The Unique Appeal Of Equity-Indexed Annuities... 4 What Is An Equity-Indexed Annuity?... 4 Features All Annuities Have In Common...4 Traditional Fixed Annuities... 6 Equity-Indexed Annuities... 7 Important EIA Terminology...8 Term... 8 Participation Rate... 8 Administration Fee...9 Cap Floor Contract Value Index Growth Index Interest Renewal Withdrawals How EIAs Differ From Index Mutual Funds Are Equity-Indexed Annuities Right For You? An Answer For The Risk-Averse Saver The Cost Of Procrastination

4 The Unique Appeal Of Equity-Indexed Annuities Equity-indexed annuities (EIAs) combine most of the features of traditional fixed annuities with the potential to earn interest based on the upward movement of an equity index. Because of this unique combination of benefits, EIAs have become very popular among financial consumers. However, it s important to understand that while EIAs offer to credit interest at a rate that is linked to the upward movement of an equity index, EIAs are generally not considered to be securities, and buying an EIA is not the same as making an investment in the stock market. In this booklet we will describe what EIAs are and are not in order to help you decide if an EIA may be right for you. What Is An Equity-Indexed Annuity? EIAs are annuities. There are many different types of annuities, but they all have the following features in common. Features All Annuities Have In Common An annuity is an agreement between an individual and an insurance company. The terms of the agreement are spelled out in a document called the policy. All annuities involve an individual paying some amount or amounts of money (referred to as premium ) to an insurance company and later getting money back from the company in one form or another. 4

5 Basic Concept Of Annuities The individual has a number of options for receiving money back from the insurance company. One feature that makes annuities unique among financial vehicles is that the individual can choose to receive a regular income that can be guaranteed to last at least as long as he or she lives. Because the individual can name a beneficiary to receive annuity values in the event of his or her death, annuity values need not become part of the individual s probate estate but can pass to the beneficiary free of probate s costs and delays. With most annuities, it is anticipated that many years may go by before the individual will choose to begin receiving income. The period prior to the time income payments begin is called the deferral period, and annuities that have a deferral period are known as deferred annuities. Deferred Annuities Have A Deferral Period 5

6 During the deferral period, the premium paid to the company has the potential to accumulate earnings and grow to a greater sum than was paid in by the individual. To encourage the use of deferred annuities as long-term savings vehicles, annuity earnings are subject to special income tax treatment. As long as accumulations stay in the annuity, they are not taxed. However, if they are removed from the annuity before the 1_ individual s age 592, then in addition to regular income tax they are generally also subject to a 10% penalty tax unless the individual has died, become disabled, or takes them in equal payments based on life expectancy. Penalty Taxes May Apply To Withdrawals Different types of annuities use different methods of crediting accumulations to policy values. From an interest-crediting standpoint, equity-indexed annuities are generally considered to be a type of fixed annuity, though with an important difference from traditional fixed annuities. To make the significance of that difference clear, let s begin by looking at traditional fixed annuities. Traditional Fixed Annuities In terms of their accumulation features, traditional fixed annuities have the following characteristics: Annuity values are supported by the full faith and credit of the insurance company. The policy specifies a guaranteed minimum interest rate that remains in effect for as long as the policy is in force. 6

7 In addition, the company declares a current rate of interest that may be in excess of the guaranteed rate. The current rate generally remains in effect for one year. At the end of that time, the company declares a new current interest rate, or renewal rate, which may be higher or lower than the previous rate, but not below the minimum interest rate guaranteed by the policy. Equity-Indexed Annuities As mentioned, equity-indexed annuities are considered to be a type of fixed annuity. That s because equity-indexed annuity values, like traditional fixed annuity values, are backed by the full faith and credit of the insurance company and a minimum guaranteed interest rate is specified in the policy. Where EIAs differ from traditional fixed annuities is in the method of determining the current interest rate to credit to annuity values. Instead of declaring a specific rate, as is done with traditional fixed annuities, the company issuing an equity-indexed annuity states that it will credit interest based on the change in value of a specified equity index. While the insurance company doesn t specify a current interest rate, it does specify the formula for determining the interest rate with reference to the equity index. Because no one knows what will happen to the level of the index, the interest rate to be credited to annuity values cannot be known in advance. Compared to an interest rate that is declared in advance, an interest rate linked to an equity index has both an advantage and a disadvantage. The advantage is that if the equity index moves upward substantially, the interest credited to an EIA may be greater than the declared rates available on traditional fixed annuities. The disadvantage is that if the equity index moves downward substantially, the EIA may be credited with only the guaranteed minimum interest rate, which may be less than the declared rates available on traditional fixed annuities. 7

8 Ups And Downs Of Linking Current Interest To An Equity Index Important EIA Terminology When it comes to the formulas used by insurance companies to determine the interest rate credited to their EIA policies, no two are exactly alike. However, being familiar with the important EIA terminology explained in this section will help you obtain a better understanding of any EIA you may be considering. Term The term is the duration of an annuity policy that is, the time period for which it is designed to be in effect. At the end of a term, the annuity owner usually has the option to renew for another term. If surrender charges are imposed on withdrawals or surrenders, those charges usually apply for the entire term, although there may be certain exceptions. Common terms for EIAs range between five and ten years, but some EIAs have shorter or longer terms. Participation Rate The participation rate is the percentage of the measured increase in the index that will be credited to an EIA s policy value. For example, if an EIA has a participation rate of 75%, and the increase in the index is measured to be 10%, the interest credited to the EIA s account value will be 7.5% (75% of 10%). The participation rate is also called the index rate for some EIAs. 8

9 Role Of The Participation Rate In Interest Crediting Issuers of EIAs generally reserve the right to change the participation rate at specified intervals. Some EIAs have participation rates that are guaranteed to remain the same for the entire term. Some EIAs have participation rates that may change each year or more frequently. The participation rates of various EIA products should not be compared without also considering the method used to measure increases in the index (discussed later under Index Growth ). There are different ways to measure the increase in the index, and some of these methods may tend to produce higher results than others, depending on how the level of the index changes. It is the combination of the participation rate and the measured increase in the index that produces the interest rate credited to EIA policy values. So you need to know how increases in the index are measured as well as the participation rate in order to understand how interest credits are determined for a particular EIA. Administration Fee This is a fixed percentage deducted from any increase measured in the index. Many EIAs do not have an administration fee. Some EIAs use an administration fee instead of a participation rate. An administration fee is sometimes called the Spread Yield. 9

10 Cap Some EIAs place a limit on the percentage of interest that will be credited to the policy value. This limit is known as the cap. Since it is expressed as a percentage, it may be called the cap rate. Floor Credited Rate Cannot Exceed Any Cap Credited Rate Cannot Be Less Than The Floor This is the minimum interest rate that will be credited to the policy value regardless of how the index performs. All EIAs have a floor. For some EIAs, the floor can be as low as 0%. Contract Value The contract value is an EIA s minimum guaranteed cash value. In some EIA policies, it is known by other names, such as the reference value or guaranteed policy value. Index Growth Index growth is the measured increase in the index for a given period of time. Index growth may also be referred to as the index increase. As mentioned earlier, different EIAs use different methods of measuring index growth. Following are descriptions of the major ways various EIAs measure index growth, though certain EIAs may employ variations on these themes. 10

11 Ways Of Measuring Index Growth Some EIAs measure index Point-to-Point Method growth by comparing the level of the index at the beginning of the term with the level of the index at the end of the term. This may be referred to as the point-to-point method. Some EIAs measure index growth by comparing the level of the index at the beginning of the term with the level of the index on the policy anniversary where it was highest. This may be referred to as the annual high-water mark method. Annual High-Water Mark Method Some EIAs measure index growth year by year, resetting the index s starting point for measuring purposes at the level where it stood at the beginning of each year. This may be referred to as the annual reset method. Annual Reset Method Some EIAs use an average measure of index growth by adding together the index s value at the close of each business day during a given time period and then dividing by the number of days, or adding together the index s value at the close of each month Averaging Method 11

12 and then dividing by the number of months. This may be referred to as the averaging method. Compared to other measuring methods, averaging may tend to produce lower index increases if the index has increased fairly steadily between measuring points and higher index increases if the index has risen and fallen substantially between measuring points. While each of these measuring methods may produce different results, the one which may produce the best result depends on how the index changes during the term of the policy. Since no one can predict how the index will change, it isn t possible to say in advance which method of measuring index growth will produce the greatest increase. The best method is the one a particular EIA owner is most comfortable with, no matter what changes occur to the level of the index. Index Interest Index interest is the amount of interest credited to an EIA s policy value. Index interest is sometimes referred to as index earnings. As mentioned earlier, index interest is calculated by multiplying index growth by the participation rate. Renewal At the end of a term, the owner of an EIA may be given the opportunity to renew the EIA for another term. In effect, renewal means using the existing EIA fund as the premium to purchase another EIA of the same type. If the owner does not wish to renew, he or she has other options: Exchange the EIA for another type of annuity Surrender the EIA for its cash value Convert the EIA fund to a stream of income payments These options may usually also be exercised during the term, but in that case, surrender charges may apply. Many EIAs provide a window of, for example, 30 or 90 days at the end of a term during which these options may be exercised without incurring surrender charges however, the government-imposed 10% penalty tax may 1_ still apply if the owner is under age

13 Withdrawals Most EIAs allow their owners to take money out of their annuity without surrendering the contract, but the terms under which this may be done vary from policy to policy. In many cases, EIA owners incur some cost to make a withdrawal. This often takes the form of a surrender charge, which is usually calculated as a percentage of the amount withdrawn. With some EIAs, withdrawal charges may be waived under certain circumstances if the amount withdrawn is less than 10% of the annuity s value, or if the owner has been confined to a nursing home, for example. Withdrawals can reduce the amount of index interest credited to an EIA. If money is withdrawn prior to a measuring point, generally no credit is given for the time the money stayed in the policy. Also, an EIA owner s access to index interest credits can be affected by the method used to measure index growth. For example, under the point-topoint method, index interest is generally credited only once at the end of the policy term, so there is no index interest to withdraw prior to the end of the term. Under other methods, index interest may be credited to an EIA policy at certain times during the policy term. Some policies provide access to these amount via free withdrawals, while others may effectively limit the amount a policyowner can withdraw by imposing vesting requirements or surrender charges. In general, any annuity including an EIA should be considered a long-term savings vehicle. You shouldn t put money into an EIA that you expect to need before the end of the policy term. The purpose of withdrawal provisions is to provide some flexibility in case an unforeseen emergency arises. In deciding among different EIAs, you may find trade-offs between the liberality of withdrawal provisions and the formulas for calculating interest credits. That is, EIAs that offer the greatest potential for interest earnings may be relatively more restricted in terms of withdrawals, and vice versa. Look for an EIA that provides a combination of withdrawal provisions and interest crediting potential that seems most comfortable for you. 13

14 How EIAs Differ From Index Mutual Funds Index investing has become popular with equity investors in recent years. Instead of trying to pick high-performing stocks based on various measures of value, index investors simply purchase shares of a mutual fund which is composed of all the stocks that belong to a particular equity index. However, while index investing and EIAs both make reference to an equity index, purchasing an EIA is very different from purchasing shares in an index mutual fund. EIAs Are Not Like Index Mutual Funds For example, an EIA cannot provide the entire value of an upward movement in an index to an EIA owner. The reason for this is that part of the EIA premium must be invested in a manner that will support the EIA s minimum guarantees. In addition, EIAs measure only the level of the index itself, which does not include the value of dividends. On the other hand, EIA principal is guaranteed against market loss. EIA owners may lose principal to surrender charges if they withdraw funds before the end of the term, but if they hold their EIA to term, they will receive their original premium plus interest based on at least the guaranteed minimum rate, even if the index has declined. Index mutual funds can provide no such guarantees. Also, some EIAs lock in interest credits based on index increases even if the index later declines. With index mutual funds, gains in value can be lost if the index later declines. 14

15 The following table summarizes the list of contrasting features just described. Feature Equity-Indexed Index Mutual Annuity Fund Provides full value of No Yes upward movement in the index Reflects value of dividends No Yes Protects principal against market risk Yes No Locks in credit for index Some designs, yes; No increases even if index later declines Others, no. Are Equity-Indexed Annuities Right For You? Whether an EIA is right for you is a question only you can answer after consulting with your financial advisers. However, there are some characteristics that should generally apply to anyone who is considering the purchase of an EIA. An EIA may be right for you if: You are looking for a long-term savings vehicle and don t expect to need the money you would put into an EIA until at least the end of the term. You don t mind not knowing exactly what interest rate will be credited to your funds, as long as it is subject to a guaranteed minimum and offers the potential (but no guarantee) of being higher than those offered on traditional fixed-rate savings vehicles. You want to earn interest at a rate linked to increases in an equity index and are willing to forego full participation in the index in return for the principal and minimum interest guarantees associated with fixed annuities. 15

16 An Answer For The Risk-Averse Saver According to a study performed by DALBAR, Inc. (Quantitative Analysis of Investor Behavior, 1994), the 10-year performance of the Standard & Poor s 500 equity index between January 1984 and September 1993 was 293%. Yet the average equity mutual fund investor made only 70%. The reason for the difference was this: in order to realize the 293% return, an investor had to buy and hold over the entire 10-year period. Unfortunately, many investors do not buy and hold. When the market goes down, they take their money out, hoping to avoid further losses. While their money is out, they miss many of the market s upswings. This behavior occurs because of risk-aversion. In trying to avoid losses, risk-averse financial consumers may actually prevent themselves from realizing the gains they seek. EIAs allow risk-averse savers the opportunity to earn a rate of interest linked to equity performance without fearing loss of principal, as long as they hold their EIAs to term. EIA owners need not withdraw their money from their policies during market downturns for fear of incurring losses they can feel reassured by the fixed annuity s minimum guarantees. They can keep their money in the policy until the markets turn back up, at which point they stand to earn potentially higher rates of interest linked to increases in an equity index. The Cost Of Procrastination Whether or not you decide an equity-indexed annuity is right for you, it makes sense to begin a consistent saving program without delay. The following table illustrates the story of John and Ray, who both have 35 years until retirement. John saves $1,000 a year for the first 10 years and nothing thereafter. Ray saves nothing for the first 10 years, then starts saving $1,000 a year for the next 25 years. As you can see, whatever financial vehicle you decide to use, one of the most important decisions you can make is to start saving today! 16

17 Dollars Contributed At End Of Each Year Year John Ray 1 $1,000 2 $1,000 3 $1,000 4 $1,000 5 $1,000 6 $1,000 7 $1,000 8 $1,000 9 $1, $1, $1, $1, $1, $1, $1, $1, $1, $1, $1, $1, $1, $1, $1, $1, $1, $1, $1, $1, $1, $1, $1, $1, $1, $1, $1,000 Total Contributed $10,000 $25,000 Total Value $99,211* $73,108* *8% annual rate of interest 17

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