S&P INDEXED ANNUITIES

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In the industry's never ending quest to sell more and more products, it came up with the equity indexed annuity. Instead of a yield based on bonds, the return is on (normally) the movement of the monthly AVERAGE S&P with certain caps and floors. But there are several methods that the companies use and they all can be somewhat confusing. For example, one company provides a return equal to the monthly average S&P of the previous year, times a participation rate which is then adjusted, as dictated under the contract, to be not less than zero- or other floor- nor higher than the CAP or maximum rate (say 14%). Suppose in year 1, the S&P goes up 20%- the client would get not 14% but about half that due to averaging. In the second year, the S&P did a -10%, but the client would just show no return at all due to the zero floor. In year 3, the S&P went up 20%- the client would get about 7%.

Other companies use a return based on the S&P's actual index. If the index was 500 when the contract was issued and 750 at the end of the 3rd year the account would have grown 50%. But they have a participation factor of 80% reducing the growth to 40%. The problem here is that if the S&P stays at 750 for, say, 10 years thereafter, the return never goes up any further until the S&P goes higher. And then you still have to address the monthly averaging

Another company converts the return to a compounded rate of return and subtracts a yield spread. In the above example, the return over 7 years could be equated to a 6% compounded rate of return. Subtract the 2.5% yield spread and you end up with 3.5% yearly return- not exactly something to write home to Mother about. There's more: Surrender charges are applicable to literally all annuities- and certainly to these. The surrender value might be the 90% of the premium accumulated at a 3% interest. That could be pretty hefty. Others remain two tier annuities. You CANNOT take a lump sum- you must annuitize over, say, a five year period. Further, most index annuities are long term investments. You should consider a minimum 10 year period 

So did you grasp much of that? Probably not, but I bet that literally no other investors did either. And if you cannot reasonably understand an investment or if the agent cannot provide an intelligible analysis, it probably shouldn't have been purchased. Nonetheless, unsophisticated investors finally joined the market after the tremendous returns from the market in 1995. Debatable if they know they must play the game for a long time. Indexed annuities are long term investments with high surrender charges, no step up in basis, 10% penalty for distributions before 59 1/2, etc. And over the long term, the annual compounded rate may only be slightly higher than that earned on a regular fixed annuity. Further, much of the return may be lost if the funds are subsequently paid out as an annuity when rates are historically very low and/or you must live for a very long time- the same as indicated previously. Annuities are not necessarily conservative investments.

MORE INDEXED ANNUITIES: 1998 Equity-indexed annuities sales hit $1.5 billion in 1996. In 1997, they are expected to reach $5 billion and $10 billion. And a good portion will be sold by agents that do NOT have securities licenses. Since they are tied to an index- and not the performance of individual securities- the government decided they were not investments within the purview of the SEC (IDIOTS!) and can therefore be sold by insurance agents- many who wouldn't know how a security worked if it bit them.

There are all different flavors of indexed annuities. They tend to offer a flat guaranteed rate- say 3%- plus a piece of whatever the S&P 500 had the past year. Here are a few of the formulas. Pay attention, there will be a quiz. (Taken from a WSJ article)

The European, or point-to-point, method divides the index on the maturity date by the index on the issue date and subtracts 1 from the result. (Other indexing methods use this same formula, with different data points.) This ignores all the fluctuations between start and finish, and becomes the simplest method to grasp. You need to recognize however that a highly fluctuating market can make a vast difference between two investors who buy the product just a few days apart. The method's name comes from European stock markets, where options can only be exercised on their expiration date.

"The Asianing method involves averaging several points of the index to establish the beginning and/or ending index. This method can help shield consumers from the risk of a market decline on the maturity date. Some companies take an average of the 12 monthly indices to establish the policy's maturity index level. This method takes its name from the Asian stock markets."

"The look-back or high-water-mark method looks at the index level at each policy anniversary. The highest of these is then taken and figured as the index level on the maturity date."

"The low-water-mark method uses the lowest of the indices on each of the policy anniversaries before maturity as the level of the index at issue. This method tends to lessen the risk of market decline."

"The annual reset, or cliquet or ratchet, method is among the most complicated. The increase in the index is calculated each policy year by comparing the indices on the beginning and ending anniversaries. Any resulting decreases are ignored. Appreciation is figured by adding or compounding the increases for each policy year."

So which is better? Well it's not the easy(?) just looking at the formulas. The contracts also spell out the investors "participation rate"- the amount that the contract provides as a percentage of the movement of the market. And that market is NOT always the S&P. "For example, a product offered by Physicians Life has a 100% participation rate, but it's not based directly on the S&P 500. Instead, customers receive 100 % of the average of the daily closing prices during the course of a year." What's that mean? " At the end of 1994, the S&P 500 was at 459. When 1995 came to a close, it had risen to 616- a pretty hefty 34 % gain. The average of the daily closing prices during 1995 was 542, a gain of just 18 %. Therefore, you'd get 18 %. That's not bad, but if you'd invested in the market yourself, you could have had that 34 % gain."

Most equity-indexed annuities offer participation rates between 70 and 90 %, and some place a fixed cap on how much you can gain. If the product has a 13 % cap, and the market gains 34 %, you're stuck with 13 %. With an 70 % participation rate and a 14% S&P return, you're only getting 70 % of 14 % or 9.1%. That's what you learn by reading the fine print. The National Association of Insurance Commissioners, a group of state insurance officials, is considering whether to develop model illustrations to help consumers considering the purchase of equity-indexed annuities.

CAVEAT EMPTOR!!!!!

INDEXED ANNUITIES: 1998 Trying to figure out how to value equity-indexed products is one of the most troublesome areas in the staid world of insurance accounting. And it has many committees devoted to this issue in turmoil. One technical task force of the actuarial association is struggling with the development of a standard reporting system. What troubles some observers is the dependence on the ever- rising stock market. They claim that some companies, all too willing to grab market share with underpriced products, believing that losses will be made up down the road with market share and an increasingly higher valued market. "From a rating agency's standpoint, one of the things we have talked about publicly is we are concerned about the proper disclosures and understanding of these products."

INDEXED ANNUITIES: (1998) The insurance industry has tried to provide products that take advantage of the significant gains of the stock market. But how in the world could an agent sell a security product without being licensed? Stupidly is most obvious. But the law does provide an exemption under Rule 151. This rule is a set of criteria and if an insurance product meets those exemptions, it is exempt from the securities registration.

From an LSW article, "insurance products are exempt from registration as securities under Section 3(a)8 of the 1933 Securities Act which defines insurance products as "any insurance or endowment policy or annuity contract or optional annuity contract issued by a corporation subject to the supervision of the insurance commissioner, bank commissioner, or any agency or officer performing like functions of any state or territory of the U.S." Rule 151 was adopted in 1986 as a safe harbor definition

The annuity contract must be issued by an corporation- the insurance company- which is subject to the supervision of the state insurance commissioner, banking commissioner or any agency or officer performing similar functions in any state

The insurance company must assume the investment risk

(The value of the contract does not vary according to the investment experience of a separate account)

(The insurance company guarantees the principal amount of the purchase payments and interest credited to the policy less any deduction the company makes for sales, administrative or other charges and expenses and credits the a specified rate of interest to net premiums and interest credited thereto.)

(The insurance company guarantees that the rate of interest to be credited in excess of the minimum guarantees will not be changed more than once per year.)

The insurance policy must not be marketed primarily as an investment. (Joke!)

O.K., let's get real. This product is sold as an investment by insurance agents who have never had any background in investments whatsoever. They should be licensed and it may happen soon.

Index Annuities (2000) Want to know the basics on how these work?  They are anything but simple and most agents don't have a clue from one to the other. In fact, some of the major insurance companies are out to lunch as well. SafeCo dropped out because they figured the market incorrectly. As of mid 1999, Fidelity & Guaranty Life Insurance Co. is left as the leader of the pack, with a 21.64 percent market share, according to The Advantage Group. Conseco Life Insurance controls a 15.92 percent of market share; Jackson National Life has 11.43 percent; and American Equity Investment Life Insurance appears in the survey's top five this year with a 9.09 percent market share. Another top seller is LifeUSA Insurance, capturing 8.5 percent of EIA sales.

EQUITY INDEXED ANNUITY LINK:  Another nice job by George Chamberlain (2006)

Annual Reset - this method, also called the ratchet method, is based on the change in value of the index over the course of the year. If the index is up at the end of the year, the reset will lock in the gains in the annuity, effectively raising the floor. If the index has declined, the annuity will retain its underlying value.

Asianing - this method uses averaging of the value of the index at many different points in time to establish the index value at the inception of the contract or the end of the term. Averaging may provide some protection against market declines at or near the maturity date of the contract.

High Water Mark - this method, also called the look-back approach, tests the value of the index at different points during the term of the contract and sets the return on the difference between the highest of those values and the value of the index at the inception of the contract.

Low Water Mark - this method tests the value of the index at each contract anniversary and uses the lowest such value as the floor for the contract term.

Point to point method - this simple approach involves dividing the value of the index on the contract maturity date by the value of the index at the inception of the contract and subtracting one from the result to derive the return.

EIA- (2007) The Monthly Cap crediting method has been shown to not perform well in either historical hypothetical analysis or Monte Carlo simulations. Point to point is better/best. Monthly Averaging and Annual Point to Point both also hold up well under hypothetical analysis.  

Want to see how difficult EIAs are? And why they need to be regulated as a security? Oy!