Equity indexed annuities (EIAs) combine features of both variable and fixed annuities. Like a variable annuity, an EIA’s return is linked to an equity index such as the S&P 500. Like a fixed annuity, an EIA provides minimum guaranteed returns. EIAs generally aren’t considered securities because the investor doesn’t bear downside investment risk when the index declines.
Even though an EIA is linked to an index (during both the accumulation and distribution phases), the investor’s gains are limited. Insurance companies typically limit index-linked returns in one of three ways:
Participation rate
An EIA with a participation rate credits only a portion of the index’s gain to the investor. For example, if the S&P 500 returns 10% and the EIA has an 80% participation rate, the annuity is credited with 8% (80% × 10%).
Cap (ceiling)
An EIA with a cap (also called a ceiling) sets a maximum credited return. For example, with a 7% cap, the investor won’t be credited more than 7%, no matter how much the index increases.
Spread rate (margin, asset fee)
An EIA with a spread rate (also called a margin or asset fee) subtracts a stated percentage from the index return. For example, if the index is up 12% and the spread rate is 3%, the annuity is credited with 9% (12% − 3%).
An EIA may include any one of the above or a combination. For example, a participation rate and a cap may exist, but no spread rate. Or, a cap and spread rate exist, but no participation rate. Or, all three or just one. The combination of restrictions enforced depends on the contract between the investor and the insurance company.
In exchange for limiting index-linked gains, EIAs provide minimum growth guarantees. Specifically, EIAs include a floor of at least 0%*, and sometimes higher. A floor is the minimum growth rate guaranteed to the investor. A 0% floor means the investor won’t be credited with a negative return even if the linked index declines. Some EIAs offer floors as high as 3%, which can produce consistent positive credited returns. However, higher floors are usually paired with lower caps and participation rates and/or higher spread rates.
*Test questions may not specifically mention a floor. You should always assume a floor of 0% exists if a floor is not identified.
Let’s work through an example to see how these features interact:
An investor contributes to an equity-indexed annuity with a 70% participation rate, 8% cap, and a 1% floor. The linked index returns a positive 10% return over the specified period just before the contract is adjusted. What return will be credited to the investor’s annuity?
A) 5.6%
B) 7.0%
C) 8.0%
D) 10.0%
Can you figure it out?
Answer = 7.0%
Start with the participation rate. The index returned 10%, so the initial credited return is 7% (10% × 70%).
Next, check the cap and the floor:
Bottom line: the investor is credited 7%.
How the insurance company measures the index return is another key contract feature. For example, does the contract measure returns from January 1 to December 31 and credit annually? Or does it use the highest or lowest index value during the period? The most common index crediting methods are:
Annual reset
With annual reset, the insurer compares the index value at the start of the period to the index value one year later (typically measured on the contract anniversary). For example, suppose the contract starts on July 1, 2022 when the index is 4,000. On July 1, 2023 the index is 4,400. The 400-point increase is a 10% gain (400 / 4,000). After that, any participation rate, cap, floor, and/or spread rate is applied.
Point-to-point
Point-to-point works like annual reset, but the two measurement dates don’t have to be one year apart. The period could be as short as a month or as long as several years. The index change between those two points is calculated, and then any participation rate, cap, floor, and/or spread rate is applied.
High water mark
High water mark compares the starting index value (often the contract anniversary value) to the highest index value reached during a specified period (usually one year). For example, suppose the contract starts on July 1, 2022 when the index is 4,000. On July 1, 2023 the index is 4,400, but the index reached 4,600 in March 2023. Under high water mark, the insurer uses 4,600 (the highest value) instead of 4,400 (the ending value). The 600-point increase is a 15% gain (600 / 4,000). Then any participation rate, cap, floor, and/or spread rate is applied.
Low water mark
Low water mark is essentially the inverse of high water mark. It compares the lowest index value during the period to the ending index value. For example, suppose the contract starts on July 1, 2022 when the index is 4,000. On July 1, 2023 the index is 4,400, but the index fell to 3,500 in November 2022. Under low water mark, the insurer uses 3,500 (the lowest value) instead of 4,000 (the starting value). The change from 3,500 to 4,400 is 900 points, which is a 25.7% gain (900 / 3,500). Then any participation rate, cap, floor, and/or spread rate is applied.
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