Equity-Indexed Annuities - A Complex Choice

A warning from the NASD

January 16, 2002

Why a Brochure 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.

Caution! Unlike variable annuities, EIAs are typically structured so that they are not securities registered with the SEC. Nor are the sales of EIAs regulated by the SEC and NASD. This means that non-registered EIAs are not subject to the customer suitability, disclosure, and sales practice requirements that registered securities are.

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.

• 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.

• 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%.

• Interest Rate Caps. Some EIAs may put a cap or upper limit on your return. This cap rate in 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%.

• 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.

• Index Averaging. Some EIAs average an index's value either daily or monthly rather than use the actual value of the index on a specified date. Averaging may reduce the amount of index-linked interest you earn.

• Interest Calculation. The way that an insurance company calculates interest earned during the term of an EIA can make a big difference in the amount of money you will earn. Some EIAs pay simple interest during the term of the annuity. Because there is no compounding of interest, your return will be lower.

• Exclusion of Dividends. Most EIAs only count equity index gains from market price changes, excluding any gains from dividends. Since you're not earning dividends, you won't earn as much as if you invested directly in the market.

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 their Web site or call their Hotline at 800-289-9999.

Additional Resources

• NASD Investor Alert, Should You Exchange Your Variable Annuity?

• National Association of Insurance Commissioners' Buyer's Guide To Equity-Indexed Annuities

• Securities and Exchange Commission's Variable Annuities: What You Should Know