Understanding Equity Index Annuity (EIA) Formulas

If you are purchasing an EIA, you will need to understand about EIA formulas and when to use them. Currently there are between 240 to 270 EIA products being sold by 50 carriers. There are a total of 7 EIA formulas out of 19 EIA formulas being used (actively) by these carriers to credit Equity Index Annuities (EIA’s). So, lets’ go over the most popular and not so popular. You must understand the following terms before proceeding:

1. EIA Term – The end-point in the EIA formula…it could be 1 yr, 2 yr, 3 yr, etc. This is not related to the surrender charge term.

2. EIA Participation – This is the maximum allowable percentage that the EIA owner can participate in an index(s) return.

3. EIA Cap – This is the maximum return that an EIA owner can receive in a given EIA term.

4. EIA Fee – This is the fee charged by the annuity company to recoup administrative expenses (such as commissions, administrative payroll, annuity company legal & accounting expenses, etc).

5. EIA Bonus – A bonus given in the first year (only) to help with taxes and/or surrender charge liquidation charges.

About 95% of all EIA’s use sold today use the following EIA formulas:

1. Point-to-Point – This is by far the most popular EIA formula. Let’s say you are selling 1 Yr. (term) Point-to-Point. This means there is two points in the formula. The starting index value (the day of purchase) and the anniversary index point. The end-of-the-day index value on the anniversary is “reset”…so the EIA owner does not lose any prior gain, and the whole procedure in calculating gains or zero’s is recalculated. Example: Starting index value = 1000 – 1200 (1 year later) = 200 point gain (or 20% gain). 20% x EIA Participation of 100% (which could be lower) = 20% (adjusted for a maximum EIA Cap of 10%) = 10% - EIA Fee of 2% = 8% + 0.00% bonus = 8% accredited to the owner of the EIA. On the 12 month anniversary, the index was 1200 – 1600 (12 months later…the 2^nd year) = 400 point gain x the EIA Participation of 100% = 400 points or 33.33% gain. 33.33% = is adjusted to the new EIA Cap of 12% = 12% - minus the EIA Fee of 2% = 10%. When do you use Point-to-Point? When you feel the market is going to be bullish.

2. Daily Moving Average – Let’s say the term of this product is 1 year. You find the end of the day’s index value…for all trading days within the year (say 225 days), and then you add the total aggregate closes, and then this sum is divided by 225 to arrive at the average. On the anniversary of the term, the product is reset…so the client does not lose any prior gains. Example: The closing ending index value for the day is 882.2, the next day index closes at 881.0, you add up the closes for 225 days, then divided it by 225 = and let’s say you get = 12.2% average return for the year x EIA Participation of 90% = 10.98 (12.2 x 90%), adjusted for the EIA Cap of 10% = 10%. 10% - EIA Fee of 1% = 9% + 0.00% bonus = 9%. As with all EIA’s at the end of the term, if the return is negative…the client receives a 0.00 return for the year. The index is “reset” on the anniversary date (every 12 months)…so the client does not lose any prior gains. When do you use Daily Averaging? In volatile markets. This EIA formula helps smooth-out the extreme peaks and valleys within the trading term.

3. Monthly Averaging – Let’s say the term is 1 year. You have 12 index points within the EIA formula. You have a closing index value (each month), and you and you add up the closes for each month in the 12 month cycle, and divide that sum by 12 to arrive at the monthly average. Example: The end of the month index close is 1250, you repeat this another 11 times, add up the total aggregate sum and divide it by 12 to arrive at the monthly average. When do you use Monthly Averaging? In sudden “volatile” bearish markets, which then return to mild-bullish markets. This EIA formula helps smooth-out the extreme peaks and valleys within the trading term.

4. Monthly Point-to-Point Cap - Let’s say the term is 1 year. You have 12 index points within the EIA formula. This is special formula, since each month has a Cap. Let’s say the monthly Cap is 3%. We have a starting index value minus the end of the month index value. The return each month cannot be greater than the monthly Cap, and then the total aggregate is add-up for the term (1 year). Example: Starting index value is 880 minus the months end index value of 1000 = 120 (13.6%) = which is adjusted to the Cap of 3%, next month we have a starting index value of 1000 and minus the end of the month index value of 798 = (-202 or –20.20% loss), we include the losses each month in the EIA Formula. We repeat these steps another 10 times (for a total of 12 months)…and whatever the aggregate sum is (that’s our index return for the term)…no averaging. Let’s say the total net aggregate for the term was 12%. 12% x an 85% EIA Participation = 10.2% - 0.00% traditional end-term EIA CAP = 10.2% - 2% EIA Fee + 0.00 EIA Bonus = 8.2% net return accredited to the client. Let’s say the net return for the term was a (–4.3%)…then the client would get a 0.00% return for the year. Next year the index is “reset” to a new starting index value on the anniversary date, and the computation is repeated. When would you use Monthly Point-to-Point? When you feel the market is going to be bullish.

5. Breakthrough Point-to-Point – These EIA Formulas us performance triggers. These EIA Formulas change the EIA Participation percentages in relation to a performance trigger. Lets say the performance trigger is 12.5%. If the client got 12.5% or lower, the EIA Participation would be 25%. But, if the return for term was greater than 12.5%, the client would get a 100% EIA Participation. Let’s say the term is 1 year. Example: The starting index value was 1000 minus the year-end index value 1200 = 200 (20%) x 100% EIA Participation = 20% minus the EIA Fee of 1% + EIA Bonus of 0.00% = 19% return to the client. Let’s say the return for next year is 10%. 10% x 25% EIA Participation = 2.5% - 1% EIA Fee = 1.5% return to the client. When would you use Breakthrough Point-to-Point? When you feel the market is going to be very bullish!

There are two EIA Formulas that are only used 16 to 20 products in the industry…which only 1% of agents use . So, let’s examine theses formulas in more detail.

1. Point-to-Point with High Water – Let’s say the term of the product is 3 years. The EIA Formula only credits the highest year returns on the anniversary date of the EIA policy, and the losses are ignored. On the anniversary date each year, the EIA compares the current index value to the original starting index value. Lets say the each year on the clients anniversary date, the returns were the following; 1^st years return was 4.5%, the 2^nd years return was 10%, and the 3^rd years return was (–6%). The “high water mark” is the 2^nd year, and the 3^rd year is totally ignored. You only examine returns on the anniversary dates only. Example: 1^st year - Starting index value is 1000 – anniversary date index value 1034 = 34 (or 3.4%), 2^nd year minus the Starting index value is 1000 minus the anniversary date index value 1200 = 20%, the 3^rd year minus the Starting index value is 1000 minus the anniversary date index value of 892 = (-10.80%). So, you take 20% x 40% EIA Participation = 8% - 10% EIA Cap = 8% - EIA Fee of 1% = 7% net return to the client. When would you use a Point-to-Point with High Water? When you can accurately guess when the market is going to take a dive, while in a bullish trend.

2. Term End Point – Most of these products have terms of 5 to 12 years. These are Point-to-Point formulas. You have a starting index value and an end point index value (5 to 12 years in the future). These products offer higher EIA Participation & higher EIA Caps…since they are very difficult to sell, and are more efficiently priced by the annuity company. Example: Lets say the term is 7 years. Starting index value is 1000 minus the end point index value in 7 years is 1700 = 70% return x 100% EIA Participation = 70%, adjusted for a 20% EIA Cap = 20% - EIA Fee of 0.00% = 20%. But 20% divided by 7 = 2.85% return per year. When would you use a Term End Point? In long bull markets.

Please choose your EIA formula wisely!

Sincerely,

John Bagwell

The Truth About Financial Products.com

www.thetruthaboutfinancialproducts.com

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Can I Lose Money with Equity Index Annuities (EIA’s)?

Equity Index Annuities (EIA’) are one of the biggest “hustles” in the market place today. I thought EIA’s were a fantastic product? That’s what the insurance industry wants you to believe. They pay the highest commission payout of all annuity products sold. I have trained thousands of agents in “advanced recovery planning,” which uses traditional CD fixed annuities, which pay the smallest commission in the annuity arena…but offer the best guarantees for the public. Yet, 90% of all agents will opt to sell the latest hot product in the EIA arena (for the highest possible commission payout), versus selling the best product & solution for the publics best interests. EIA’s have some serious dangers to them…and one of these dangers is the “minimum guarantee” for the product. So, let’s examine the minimum guarantee first.

The minimum guarantee is the least understood component of EIA’s. The minimum guarantee is the main feature that you rely on…to save you if the stock market falls. Currently the minimum guarantee only applies to 87.5% of the initial investment premium. Based on the new Non-Forfeiture Obligation Law, the minimum guarantee is set at a percentage rate (usually 3%)…and only applies if you withdraw your money from the EIA…based on certain index conditions not being met! Sounds tricky…and it is!

If the EIA index crediting formula returns are greater than 3%…the minimum guarantee provision does not apply. First you must understand how the minimum guarantees is calculated, and when can the minimum guarantee be applied to your account.

The key to the minimum guarantee is the following:

1. Is the guarantee based on simple or compound interest calculations?
2. Does the minimum guarantee only apply if owner of the EIA holds the policy to the end of the surrender period, or can the EIA policy be liquidated before the surrender period is over (and be accredited with the minimum guarantee)?

There are three scenarios which the client may get less than the original investment principal (by taking a withdrawal):

1. Early Surrender/Simple Interest – Example: Client invests $10,000, the market is bearish, he receives 0.00% return on the EIA Index Formula, and he withdraws his money just before the surrender period is over. Calculation: $10,000 x 87.5% = $8,750 x 3% (the min. guarantee yield) = $262.50 = Total Amount Paid to The Client = $9,012.50

2. Early Surrender/Compound Interest – Example: Client invests $10,000, the market is bearish, he receives 0.00% return on the EIA Index Formula, he withdraws his money early…before end of the surrender period. Calculation: $10,000 x 87.5% = $8,750 x 3% (the min. guarantee yield) over three years = $811.36 = Total = $9,561.31 x 5% early withdrawal penalty (on an 8 year charge product) = $478.06 = Total Paid Out to The Client = $9,083.24

3. Early Surrender/No Interest Accredited - Example: Client invests $10,000, the market is bearish, he receives 0.00% return on the EIA Index Formula, he withdraws his money early…before end of the surrender period. The contract stipulates the policy owner must hold the contract to the end of the surrender period…to receive any minimum guarantee interest. Calculation: $10,000 x 87.5% = $8,750. The product is surrendered in the 5^th year (within a 7 year surrender charge product as example) = $0.00 interest accredited = $8,750 x 2% early withdrawal charge = $175 = Total Paid Out to The Client = $8,575.

Agents are marketing EIA’s as the product to save the public from market disaster…yet the product can lose money!

Now, let’s examine an EIA policy based on the following features:

1. The minimum guarantee is based on 87.5% of the initial premium at a 3% yield (compound interest).
2. The contract term is 8 years.
3. The market is negative for 8 straight years. Remember, the EIA policy has a 0.00% floor when the index return is negative.
4. The Client withdraws immediately after the surrender period is over.
5. Initial investment principal is $10,000 dollars.

Example: $10,000 x 87.5% = $8,750 x 3% (compounded) over 8 years = $11,084.23

The client made $1,084.23 over 8 years (which is a total yield of 10.84% over 8 years), which is $135.52 per year or 1.355% effective yield per year. I can get better yields in a money market! If you factor in inflation, you’re right back were you started.

To receive the Minimum Guarantee in an EIA…you must hold the investment to the end of the surrender period. In addition, most EIA compute simple interest. Example: $10,000 x 87.5% = $8,750 x 3% (simple interest) = $262.50 = $10,262.50 accredited to the client if he takes a withdrawal after the surrender period has expired, and there was a 0.00% accreditation each year for the term of the product (based on his EIA Formula).

Based on history, the stock market has failed to produce a 3% return over 10 years only 5 times (or 7% of the time). So, from the annuity company’s point of view, there is only a 93% chance the 3% minimum guarantee will ever happen. Yet, we are in a recession, and it is likely to get worse. The possibility of the having a 0.00% return every year (within an EIA product)…is very likely! 

Sincerely,

John Bagwell

The Truth About Financial Products.com

www.thetruthaboutfinancialproducts.com