HOW TO EVALUATE
EQUITY INDEX ANNUITITES

Dr. Geoffrey A. VanderPal
DBA, MBA, CFP®, CLU, CFS, CTP, RFC®
President, Elite Financial Planning
Group of America, Inc.       
Las Vegas, Nevada

As many Financial Services Journal On-Line readers well know, Equity Index Fixed Annuities have been around since February of 1995 when Keyport Life developed the concept of providing returns linked to the S&P500 index with the safety of a standard fixed annuity.  An equity index annuity provides a guarantee of principal, guarantee of a minimum return over time, and allows for growth participation pegged to a stock or bond index on a tax deferred basis.  There are advantages as well as disadvantages to these programs.  Some advisors are unaware that Equity Index Fixed Annuity programs exist and exactly how they function. Over the past three years advisors have been seeking safer alternatives to grow client wealth with minimal risk to capital.

An Equity Index Annuity, or EIA, is a fixed annuity and does not require a securities license to solicit clients. The Equity Index Annuity has gained in popularity and sales have increased dramatically during the past 11 years.

Equity Index Annuity Sales
	1997	$ 3.00	Billion
	1998	$ 4.20	Billion
	1999	$ 5.15	Billion
	2000	$ 5.25	Billion
	2001	$ 6.50	Billion
	2002	$11.70	Billion
	2003	$14.01	Billion
	2004	$23.00	Billion
	2005	$27.26	Billion
	2006	$25.30	Billion
	2007	$25.20	Billion
Source: The Advantage Group

Annuities over the years have received negative press, some fairly and some unjustified.  Annuities do provide a good alternative for retirement savings when other sources of retirement vehicles such as IRAs and qualified plans are maximized.  Due to the unique nature of the EIA with its principal protection and index linked returns, an EIA may be more appealing than standard fixed annuities without the market risk of variable annuities or mutual funds.  

The EIA typically provides a guaranteed minimum return between 2 to 3 percent annually over the term of the contract, even if the index linked return is flat or negative during the annuity contract period. Index annuities have come under scrutiny through FINRA regarding the sales practices and suitability for some clients.  The controversy surrounds the issue of whether FINRA has jurisdiction over a fixed insurance such as equity index annuities.

A study was conducted by The Advantage Group, a research firm in St. Louis.  They examined 19 firms with 23 EIA programs for a five year period from September 2, 2002 through September 30, 2007 and concluded that 6 products provided an annualized return of 7% to 8%.  All the rest credited interest results in the 5% to 6% range.  I remind readers to be aware that different crediting methods can affect the index linked return outcomes.

According to The Advantage Group, from 1997 through 2007, the 5-year annualized returns for index annuities averaged 5.79% versus 5.39% for taxable bond funds, and 4.73% for fixed rate annuities.  From 1997 through 2007, the EIA and taxable bond funds had a negative 0.11 correlation between the index rate and bond returns.  This is an important aspect for portfolio diversification for clients.  During this same period certificates of deposit earned 2.5% annually. The average issue age for clients purchasing index annuities is 64-years old.

Your paramount philosophy is:
"It's Not What You Make!  
It's What You Keep!"

The volatility of the stock market requires for large upward spikes in investment return to elevate above the market troughs or losses.  The EIA allows for protection of principal in down markets and provides for a zero percent return instead of a negative return during market declines.  Many EIA programs provide a minimum guarantee of 2 or 3 percent annually if the index linked return is less than the minimum guaranteed return at the end of the annuity contract.  It is important for financial advisor's and their clients to be aware that annuities require contractual periods whereby penalties may result for early withdrawal beyond free withdrawal amounts and events such as death, disability, long-term care, hospitalization, and unemployment. These provisions are clearly marked in annuity contracts and sales literature.

An EIA is ideal for clients who would like to participate in market returns yet are uncomfortable with market risk.  A financial professional understands that even as people age, inflation continues to erode the buying power and savings of clients.  Over time, the highest investment returns have resulted from the equity markets.  With the uncertainty of the stock market, over valuation of bond and real estate uncertainties and low interest rates, clients are seeking safe alternatives to provide returns immune from market risks.  According to The Advantage Group, index annuities provided 27% to 254% more interest than the average certificate of deposit (earning 2.5% annually) during the five year period between September 2, 2002 and September 30, 2007.

Interest Crediting Methods

In order to better understand the mechanics of an EIA, understanding the major crediting methods used to calculate index linked returns is crucial to evaluate potential returns for a contract owner.

• Point-to-Point (PP): The point-to-point design credits interest based on the difference between the index value at the beginning and end of a period of at least one year.  Keep in mind that the change in the index is a "price change only" measure and does not reflect dividends.  For example, the S&P 500 index is at 900 and at the end of the crediting period the index result is 1,100. A gain of 22 percent is realized.  The PP can be monthly,  annual with an annual reset or over a period of time or also known as a term point-to-point which normally ranges from seven to Twelve years without a reset.  The point to point term method works best in upward trending markets over time.  Where as, the point to point with annual reset tends to work best in uncertain and volatile markets.

• High Water Point (HP): The high water point or high water-mark, is a variation of the point to point term method. Rather than using the ending point, instead, the calculation for an HP is based upon the highest obtained value during the term of the contract based upon annual contract anniversary index values.  For example, if the index increased to double its original value on the first anniversary date, and then proceeded to decline for the remaining contract period, the high water point method would calculate an index return of 100 percent.  The high water-mark is locked in no matter how much the market may go down.  The high water mark method performs best when the market rises to a high level, and then surrenders a significant portion of the gain over the remainder of the contract term.  The high water mark represents less than 1 percent of sales and has not been a major method in over 7-years.

• Averaging Method (AM): The averaging method averages the index performance over a period of time on a monthly, weekly or daily basis.  For example, the ending index value of a monthly averaging method would be calculated as the last 12 monthly anniversary values added and divided by 12 to create an average annual value.  In this case, averaging protects the contract holder from sudden declines in the index.  With averaging methods, a loss of upward performance in the index calculation occurs; which can be a major long-term draw back.  The averaging method works best in volatile markets over a limited period of time.

In addition to the three main crediting methods, there are variations that can affect index performance that should be clearly understood to better understand the performance of an EIA.

• Annual Reset (AR): The annual reset credits interest annually to the contract-holder.  As a hedge against unforeseen financial circumstances, such as increased hedging expenses, the insurance company usually reserves the right to alter participation rates annually.  The AR method is advantageous for locking in or ratcheting contract holders' earnings annually.  For example, if using an AR point to point EIA, the Standard & Poor's 500 index value started at 1,000 and ended at 1,100 on the first contract anniversary and then ended at 900 on the second policy anniversary, the resulting return, using a 90 percent index participation and a 0 percent floor return for each policy year, would be 9 percent cumulative for the two-year period where as a standard index mutual fund would have experienced a 20 percent loss during the second year and a cumulative loss of 10 percent.  In this scenario, the AR point to point EIA produced 19 percent more return over two years compared to a standard index mutual fund.  The AR method works well under volatile market conditions and has become popular in the past two- years. This method also provided the best index participation potential when taking our periodic or systematic withdrawals.

• Cap: A cap is the maximum amount of indexed interest credited to an EIA.  A cap is often used in combination with a participation rate and is common to EIA's with an annual reset design.  This can limit the upside market potential to a contract holder and many contracts allow for annual readjustment of the cap.  The adjustment is based on index option pricing and how much the insurance company can purchase for index participation.  An example of a cap is an EIA which limits index returns at a particular level or ceiling.  If an EIA had a cap of 10 percent, then the EIA can only provide up to a 10 percent return for a given period of time.

• Floor or minimum guarantee: The minimum credited interest rate also known as the guaranteed interest rate.  Usually, the floor is either a 90 percent or 100 percent guarantee of principal invested with a 3 percent annual interest credit.  This can vary by annuity company or by specific program.

• Participation Rate: The percent participation of an increase in the market value of the index used to determine the amount of indexed interest to be credited to a contract holder.  The percentage stated (participation rate) is multiplied by the amount of increase in the index value to determine the indexed interest.  For example, when the S&P 500 value increases 10 percent, an EIA with an 80 percent participation rate will receive indexed interest credit of 8 percent.

• Index term: The specific period of time during which an EIA policy is indexed or contract period.

• Yield Spread or Asset Fee: The yield spread is often called the asset fee or margin reduction.  It is stated as a percentage deduction from the amount of indexed interest.  It is used to cover the expense of purchasing index options and other underlying expenses.  The yield spread deduction has the same effect as a participation rate of less than 100 percent would have.  For example, if the index increases 10 percent, an EIA contract with a yield spread of 2 percent would net interest of 8 percent after deducting the fee.

• Bonus: Some EIA programs offer an upfront bonus to clients.  This can be utilized to offset previous client losses or a surrender fee for early redemption of a previous investment however annuities require longer contract periods for the client.

• Liquidity: Most EIAs offer a 10 percent to 20 percent standard withdrawal feature while providing a nursing home or terminal illness waiver which may allow for a substantial or complete withdrawal without penalty.  Typically most contracts allow for full contract value without penalty upon death of the annuitant.

How EIAs Function Internally

The mechanics of the EIA are based upon a targeted maturity investment grade fixed income portfolio and equity index (European Call) Options of a particular index.  A European Call Index Option is a derivative security based upon the underlying increase in value of an index over a period of time with a set end date for exercise.  The vast majority of contract holders' funds are placed into the fixed income portfolio (similar to standard fixed annuities).  The investment grade fixed income portion of the underlying annuity portfolio accounts for between 70 through 98 percent of the initial funds invested depending upon the type of crediting method utilized and the term or maturity period of the contract. An EIA contract can range from five years through 16 years for contract maturity.

An EIA with a point-to-point design over a term or period of time (not annual reset) will invest the funds into an investment grade bond portfolio targeted to the contract maturity.  Calculated upon a discounted present value of the bond portfolio, the discounted amount is placed into customized equity index options for the maturity period.  As the bonds mature in the underlying portfolio, the matured bond value provides the principal protection and the minimum guaranteed contract return is based upon a portion of the dividends generated.  

The typical point-to-point crediting method calculates the index return based upon the beginning point and the ending point.  During the interim the return is subject to market volatility, not the principal.  As an example, the annuity company is able to purchase a bond portfolio, maturing in 9 years, generating a 5 percent return.  The annuity company provides for a 100 percent guarantee of principal, with a 2 percent guaranteed yearly return.  This leaves 3 percent net (5 percent return minus 2 percent guarantee) left to use as a discounting factor over the 9 year period.  

Based on the present value using a 3 percent discount, the annuity company places about 77 percent of the funds into the fixed income portfolio, while the remaining 23 percent (less internal fees) is used to purchase the index options. Below shows the hypothetical allocation of a term point-to-point EIA program based upon the example above.

The participation, caps, and asset fees/spreads are directly dependent upon the mechanical structure of interest yields on bonds and the pricing of index options.  Lower bond yields decreases the amount of options to be purchased on the index since more funds on a PV (present value) basis must be placed into the bond portfolio for the principal guarantee and minimum guaranteed return. Index option premiums are priced on market volatility.  The more volatile the market, the more expensive the option premium.  In volatile markets, this translates into less index options being purchased which reduces the participation of index participation in an EIA.

The EIA with an annual reset point to point model works in a slightly different manner than the traditional point to point over a term greater than one year.  The annual reset feature allows for gains to be locked in annually and previous gains are not affected by current or future market losses.  This is accomplished by the insurance company annually purchasing equity index options with a portion of the underlying bond portfolio dividends and yields. This is ideal for clients withdrawing funds systematically for income since it has the least affect on index participation over time.  The annual reset is structured with the annuity company purchasing index options annually.

Some point-to-point annual reset EIA's  provide a 100 percent principal guarantee with a 3 percent compounded annual return as a minimum contractual obligation with market linked returns based on an index, whichever is greater for the client over the EIA contract period.  This is very attractive to retirees who want safety and need funds to grow beyond the rate of inflation.

A common question asked are whether caps, spreads or participation rates have a significant affect upon contract earnings for clients and how those limitations affect the overall return compared to the actual index.  A financial planner must be able to weed out the programs that have the least favorable terms. Research has shown that a cap has a lesser impact upon EIA index returns than an annual asset fee or yield spread.  The point-to- point with annual reset tends to be more dynamic since the participation rate or cap levels can change annually.

Since interest rates are at a lower point historically and index option premiums are at higher levels in the past year, due to market volatility, using an EIA that can increase annual participation or increase cap levels is a forward thinking concept that can be advantageous for your clients as long as the insurance company continues providing a competitive participation rate and cap level.  Going forward as the equity markets become less volatile, the index option premiums will decrease allowing higher annual participation levels and higher caps for EIA index returns.

The EIA is not designed for outperforming the index long-term but instead designed to allow for investors to potentially receive better returns over standard fixed instruments without market risk.  To examine this concept further, you can analyze various time periods to compare a conservative annual reset point-to-point.

The strongest EIA crediting methods are the monthly point to point, point to point with annual reset and the high water mark. Since the return of the EIA is predicated upon the return of the indices available, there is no guarantee of future performance.  Laddering a portfolio with different crediting methods and several indices over various maturity periods will provide the best potential returns in various market situations.  The averaging method, whether it is monthly, weekly or daily averaging, tends to perform at about 50 to 60 percent the return of a point to point and point to point with annual reset over time.
Keep in mind that even though EIAs do not provide complete participation in an index, based on various crediting methods and market anomalies, you may actually receive a better return over time than in various mutual funds or variable annuities.  Considering variable annuities with mortality and administration expenses (M&E), sub-account management fees and other various charges account for 2.50 percent to 4.00 percent of annual expenses that erode market returns.  A variable annuity sub-account that earned 10 percent in the market would net between 6.00 percent to 7.50 percent to the client's account -- after internal fees are deducted from earnings.  An EIA does not have sales loads, management fees or 12b-1 marketing fees.  Instead, the insurance company skims a small amount from the underlying portfolio which lowers participation in the market index to cover administrative costs and commissions to brokers.

Some hurdles you may experience when explaining this concept to clients is conveying the mechanics of how the insurance company actually invests the money and why there is no market risk to the client.  Other issues arise when placing client funds into longer term contracts even though longer maturity EIAs tend to provide better potential index participation.  This is premised on longer term fixed income instruments providing higher dividend yields that in turn allow for more index options purchased to increase index participation for the contract holder.

VanderPal's Six Rules For EIA Evaluations

As with any product, there are particular items to avoid so that your client is assured of receiving the best available program.  I recommend the following guidelines when evaluating EIA programs:

1. Avoid an annuity that requires a period of payments made to the owner or beneficiary due to death of the annuitant.
2. Avoid any EIA that does not provide full accumulated earnings growth up to date of death. A few EIA providers will only guarantee original value invested if death occurs before maturity.
3. Avoid monthly, weekly or daily averaging over long periods of time. Averaging works well in volatile markets not in upward linear moving markets. Many EIA programs allow changing crediting methods yearly. Utilizing an averaging method long term will decrease potential earnings long-term.
4. Avoid low participation levels with low index return cap.
5. Avoid asset fees or spreads to reduce erosion of credited index returns.
6. Seek programs with contract periods of no more than 10 years.

About Geoffrey A. VanderPal, DBA, MBA, Ph.D. CFP, CLU, CFS, CTP, RFC:  Before founding the independent financial and investment advisory practice known as the Elite Financial Planning Group, Inc., in Las Vegas, Nevada, the author spent ten years working with Citibank/Citicorp Investment Services, Inc., and First Union Securities, Inc., in senior financial planning and investment advisory positions.  At the age of 25 he created and later sold a mutual fund company that was founded with an innovative balanced portfolio methodology providing risk reduction to investors.  Geoffrey currently serves as Treasurer of a $100 million technology firm in Indianapolis, Indiana.

Dr. VanderPal holds advanced certifications and degrees that lend to his experience.  He obtained his Bachelor of Science degree in business with majors in finance, marketing and management from Columbia College and his Masters of Business Administration from Webster University.

Dr. VanderPal, in early 2006, earned a Doctorate in Finance and Business Administration (with honors) from Nova Southeastern University while completing a dissertation researching various hedging strategies and risk/adjusted return analysis methods based upon equity index investing. 

He is a Certified Financial Planner, Chartered Life Underwriter, Certified Fund Specialist, Certified Treasury Professional and Registered Financial Consultant.  These designations require thousands of hours of study and preparation culminating in extensive yearly examinations.

Dr. VanderPal completed his Certification in Financial Planning from the University of California at Berkeley.  Dr. VanderPal is a supervisory principal and has obtained seven securities and five insurance licenses.  He is believed to be "… the most credentialed financial advisor in Nevada," and has worked with thousands of individuals and families during the past fourteen years.

An in-demand lecturer, Geoffrey has spoken on financial subjects to community groups, civic, social, fraternal, religious, and business organizations.  Dr. VanderPal was named in 2005 by the Consumer's Research Council of America, as "One of America's best financial planners."  Writing in Advisors magazine, Forrest Wallace Cato called Dr. VanderPal, "One of America's leading financial planners."  Dr. VanderPal has been quoted or featured in Millionaire Magazine, Mutual Fund Magazine, Chicago Tribune, Northwest Herald, Nevada Business Journal, Journal of Financial Planning plus other publications.  He has traveled in over thirty countries and serves, by diplomatic appointment, as an Honorary Counsel to the Slovak Republic (EU) with Consular jurisdiction in Nevada and Arizona.
   
He is also appointed as an Adjunct Financial Professor with several universities.  Professor VanderPal also serves as a Securities Arbitrator with the National Association of Securities Dealers, now FINRA, and the New York Stock Exchange (NYSE).  He was the past President (2004-05) of the Financial Planning Association of Southern Nevada and a member of the International Association of Registered Financial Consultants, Las Vegas.