Do-It-Yourself Equity-Indexed Annuities

Equity indexed annuities offer retirees a compelling combination of guaranteed income and participation in the market’s upside. But EIAs are exceedingly complex and have been the subject of numerous regulatory challenges.  For those who seek a simpler alternative with a comparable return profile, a combination of fixed-income securities and options is viable choice.

I will describe how advisors can construct a do-it-yourself portfolio, to which EIAs – also known as fixed-index annuities – can be compared.   First, however, let’s look at some of the complexities of today’s EIA offerings.

With an EIA, an insurer provides a guarantee that you will receive a minimum rate-of-return on your investment over a stated time period, along with upside potential based on the performance of a market index, such as the S&P 500 or the Dow Jones Industrial Average.  If the index generates a positive return over the period, the purchaser receives a fraction of index’s price return (not including dividends) and/or 100% of the price gains up to a specific limit.  The purchaser of an EIA typically agrees to pay a surrender charge if he or she ends the contract prior to the contractually specified end date. 

There are various permutations on this basic idea, but the simplest is one in which the potential for receiving a return greater than the guaranteed minimum is determined by the change in the market index between the beginning and end of the contract.  This is referred to as a “point-to-point” or “European” EIA.  An investor may not receive all of the price gains from the index.  The fraction of the price appreciation that the investor is credited is referred to as the participation rate.  If the EIA has a specific participation rate (say 80%), and the index’s price gains 6% while the EIA is in force, the purchaser would receive a return of 6% x 80% = 4.8%.  Some EIAs also have a cap, which limits the rate-of-return that you can receive regardless of how well the index performs. 

Criticisms of EIAs

While EIAs, in theory, are designed to offer the best of both worlds, critics say they are too expensive and too complex. 

Indeed, the complexity of these products is evident in this product listing, which is maintained by a firm that promotes annuities.  Participation rate and cap are only two of the characteristics that define an EIA; the buyer must also consider features such as the frequency of reset, the averaging method and the creditworthiness of the EIA’s issuer. 

Moreover, the fees for EIAs are not transparent.  Because these products are not regulated as a security by the SEC, issuers are not required to disclose the built-in fees that investors will incur. 

Wall Street Journal columnist Jason Zweig wrote a widely cited article in September of 2010 criticizing EIAs.  His main problems with EIAs were sales commissions that can range from 5% to 8% of the invested principal, as well as the ability of the issuer to reset the cap on an annual basis.  Zweig claimed, for example, that while typical caps were around 6%, some insurance companies had the right to ratchet the cap down to 1.5%. 

He was also concerned about the liquidity constraint inherent in EIAs.  Some EIAs have surrender charges as high as 12% of the principal if a purchaser ends the contract within the first year.  Bloomberg published a similarly critical article in January of 2011. 

FINRA issued an Investor Alert on EIAs in September 2010, which explicitly warned that these are complex financial instruments and which outlined a number of the key differences among contracts and how these may affect investors’ outcomes.  The FINRA statement also mentioned a number of the issues outlined by Zweig in his Wall Street Journal piece

Finally, because of the wide variety of contracts available and the general lack of transparency, it is very hard to determine how well EIAs have served their stated objectives.   This issue was examined in an Advisor Perspectives article earlier this year.

Do-it-yourself EIAs

Despite an EIA’s complexity, it’s actually quite easy to create a financial structure that mimics their desirable features.  We can learn a considerable amount by exploring these types of portfolios.  An EIA-like portfolio consists of an income and a capital appreciation part.  I will examine each of these in turn.