Equity-indexed annuities are fixed, deferred-annuity products introduced in the mid-1990s to enhance the appeal of fixed annuities. Fixed annuities were very attractive during the high interest rate era of the 1980s and early 1990s. However, their appeal waned as interest rates dropped and stock market yields significantly surpassed the yields in traditional fixed annuities.

Some insurance companies have introduced equity-indexed annuities as a product that still offers guaranteed minimum interest rates and at the same time will pay a higher return if the specified stock index increases enough to provide a higher yield. These products are promoted as the best of both worlds�fixed-interest debt investments (bonds) and equities (stocks). They are designed to appeal to persons who want to participate in high equity investment yields without bearing the full investment risk that must be assumed in the purchase of a variable annuity.

Variable annuities are still the only annuity products that provide most of the full yield of the equity investments to the owner/annuitant. The equity-indexed annuity provides only a portion of the capital gain of the stocks making up the applicable index (commonly the Standard & Poor�s 500 Index). Since the formulas look at the value of the index only at anniversary dates, there is no way to capture the dividend income (if any) of those stocks in the formula approach used in the equity-indexed annuities. It is difficult for prospective purchasers of these annuities to find accurate information about past performance of the capital gain portion of the index because most sources report the combined total return�both capital gain and income from dividends. Over the past 20 years about 20 percent of the total return of the S&P 500 has been from the income portion.

Prospective purchasers of equity-indexed annuities need to understand that their potential return based on increases in the value of the index is determined by the actual formula approach set forth in the contract. Generally this formula includes participation rate as well as an increase in the index from the beginning of the term to the acceptable anniversary-date value of the index. Some contracts use the increase in the index to the anniversary date during the specified term period (ranging from one year to 8 years, depending on the specific contract) when the index reached its highest value. The participation rate is a percentage (always less than 100 percent) of the defined increase that will be used to calculate the crediting amount. This participation rate is set by the insurer and is subject to change. Some companies do not even specify the current participation rate in their promotional materials. Often the participation rate is guaranteed for a specified first term, such as 5 or 7 years. The insurance company reserves the right to change the participation rate at the expiration of each term but usually guarantees the then-current rate for the subsequent term.

Most contracts anticipate a series of terms of uniform length, much like renewals of 5-year term life insurance. However, some contracts reserve the insurer�s right to modify the term period available for continuation at the expiration of any existing term. In most designs, the higher increase from the index calculation is available only at the end of the applicable term unless the owner dies or the contract is converted to benefit-payout status (annuitized) before the end of the term. The higher value based on the index will not apply if the contract is terminated before the end of the term.

The participation rate is very important in that it restricts the amount of the index gain that can be applied (if any) to get more than the guaranteed yield. There is also a link between the participation rate and the guaranteed interest rate. Higher participation rates may be available from some insurers if the purchaser will accept a lower guaranteed interest rate. One company guarantees that the participation rate will never be lower than 25 percent. Example illustrations are often based on 80 percent or 90 percent participation rates. It is reasonable to assume that participation rates range from 25 percent to 90 percent. The participation rate cannot be changed more than once per year under most contracts.

Another aspect of the indexed benefit is that some contracts include a cap on the crediting rate that can be applied to the accumulated value of the contract. This may be a single stated percentage applicable to the whole participation period (contract term). It can be stated as an annual equivalent that in turn determines the aggregate limit for the full participation period. The existence of such a cap prevents even the full formula participation in times of very rapid index increases.

As a protection on the downside, most contracts specify a floor of zero percent as the minimum interest crediting rate applicable to the accumulated value. This prevents the application of a negative percentage in the formula to reflect plunges in the index value.

The intent is that the fixed-interest-rate guarantee is the worst possible outcome and if the equity index does better, the accumulation may be even better than the guaranteed accumulation. The marketing material touts this feature as presenting the best of both worlds. Equity-indexed annuities are clearly designed to appeal to purchasers who want higher yields than bonds have provided in the mid 1990s.

Equity-indexed annuities satisfy another objective of the insurance companies. They are classified as fixed annuities and can be sold by agents who are not licensed to sell variable products. Thus the agent has a product that is partly influenced by equity performance and that offers a minimum-accumulation guarantee. The agent can sell the product without having to acquire a new license and thus avoids the training requirement and commitment necessary to enter the variable-annuity market.

It is worthy of note that the Securities and Exchange Commission (SEC), which is currently examining insurance products, could decide that equity-indexed annuities really are a variable product rather than a fixed product. Many experts argue that the current definitions of terms adhered to by the SEC are broad enough for such an interpretation without changing any existing authorizations or guidelines. Others believe equity-indexed annuities cannot be classified as variable products without some action to change the SEC definitions.

The minimum guarantees under equity-indexed annuities are lower than those for traditional fixed annuities. In fact, the rates actually guaranteed apply to less than the full amount paid as a premium. It is common to apply the guaranteed rate to 90 percent of the amount paid to purchase the annuity. That percentage (often 10%) not included in the guarantees can be used to cover insurer expenses. With this approach it usually takes 3 or 4 years before the guaranteed amount equals or exceeds the initial purchase amount. The guaranteed rate may result in only a 10 percent gain over a 7-year term when calculated on the full original purchase price. The specified interest rate applied each year to the contract value is set forth in the contract and remains fixed unless a negotiated change is later agreed to by both the contract owner and the insurance company. Many of the existing equity-indexed annuities� guaranteed rates are in the range of 2 percent to 3.5 percent.

At the end of each term, or participation period, the value of the annuity will be the greater of the following three amounts:

The equity-indexed annuity can be converted to benefit-paying status at any time prior to the maximum age specified for mandatory benefit payout. For qualified annuity contracts the benefit payout must start after the annuitant reaches age 70 l/2. For nonqualified annuities the benefit payout does not have to begin before age 85 with some insurers and may be pushed beyond that by an insurer in the future.

Tax law forces payout of qualified annuity contracts starting at whichever time is later:

Most equity-index annuities in force were issued before the 1996 tax law change that permits delay of annuitization until retirement if that is later than
age 70 1/2. Consequently many equity-indexed annuity contracts used for IRA purposes or other qualified plan use will force the start of benefits before retirement for people working beyond that age.

The tax law does not mandate a maximum age for distributions to start for nonqualified annuities (those purchased with after-tax dollars). It is the insurer that imposes the maximum age constraints on nonqualified annuities.

The benefits-payout options are the same as those for any other type of fixed annuity contract.

The taxation of equity-indexed annuities is the same as that for any other type of fixed annuity contract.

Although the most commonly used index is The Standard & Poor�s 500 Composite Stock Price Index, some insurers use another index specified in the contract. These are generally established indexes that are regularly published in financial publications such as the Wall Street Journal. However, some insurers have chosen to use international indexes or a composite of two or more established indexes. This puts the definition of the index under the insurance company�s control, and theoretically the company could change the definition of the index after the contract is created. This leaves open the possibility of intentional manipulation of the index in the future.

The contracts often set forth an alternative index to be used in case the primary index ceases to exist in the future.

All financial products involve risks, and the equity-indexed annuity is no exception. The issuer needs to invest in assets that will provide an adequate return to honor the contractual promises.

Since the index participation promises some results that are above those of bond returns when the stock index outperforms the bond market, how will a company invest assets to produce the higher increment? The closest match will come by investing some funds in the same stocks that make up the index. However, some insurers have chosen to invest in derivatives and other financial assets that they feel will track well with the index even though these choices are not a composite of the items that make up the index. Over the long run there could be a significant difference between investment results and contractual obligations. If the investment results exceed the contractual obligations, there will be no problem honoring the annuity contract terms. On the other side, though, underperformance of asset returns relative to obligations could threaten the insurer�s financial viability. Purchasers should feel more comfortable with issuing companies whose investments more closely resemble the index the benefits are related to.

The equity-indexed annuity concept is an acceptable composite approach to fixed annuities. It needs much more explanation than the traditional fixed annuity contract. If purchasers do not fully understand the features and the very limited extent to which these annuities participate in the index, they may later be very disappointed and revert to class action suits to seek redress. A small number of insurance companies are taking a very aggressive stance on both indexes and investments that could potentially tarnish this product. That would be unfortunate because the concept is a sound one and many insurers seem to be taking a responsible approach to both choice of the index to apply and the offsetting asset portfolio mix.

Equity-indexed annuities became highly visible in the market during the 1996�1998 interval. In fact, there are new equity-indexed life insurance policies available in the marketplace. Time will tell how successfully equity-indexed products satisfy the needs and desires of the purchasing public.