How do you choose what is
best for you?
To begin with, you should understand the
basic designs and features of indexed annuities...
(see definitions below of some
"key" phrases and terms if need be)
Long Term
Point-to-Point
If, for example, the last day of the Long
Term Point-to-Point term falls at “Point A”, below the
initial start point, it is a “loss”, and as such, would register a
“zero” for the index term. In such an event, the minimum guaranteed
value for the term would be paid. If, on the other hand, the term ended at
“Point B”, which is higher than the initial start point, then a
gain would be registered for the index term. The Average End design,
sometimes referred to as the “Asian End” design, is a type of Long
Term Point-to-Point design.
This is possibly the
most basic type of equity index method
As the name implies, there are only two
days in this index calculation method, the starting point and the ending
point. For example, if Point A (the starting point) is 500 on an index and
Point B (the ending point) is 550, then an unadulterated or pure
Point-to-Point method would register a gain of 10 percent. The calculation
is as follows:
(550 -
500)/500=50/500=1/10=10%
That number would then be multiplied by
the participation rate to determine the index gain for that period.
For Example: .85 X
10%=8.5%
So far, two pure Point-to-Point basic
designs have emerged, the “Annual Point-to-Point” and the “Long Term
Point-to-Point”. In the classic unadulterated version of the Long Term
Point-to-Point index method, the only days that count in the index gain
calculation are the first day (the issue date) and the last day of the
index term. Whatever the market did in between is IRRELEVANT.
Only the first and last day of the entire index term count.
AVERAGE END
A significant variation of the Long Term
Point-to-Point design is the “AVERAGE END”design. (The Average End is
sometimes referred to as the “Asian” End.) With the Average End,
instead of having one day at the end, there are a series of days, usually
weekly or monthly, to establish the end point for determining gains. Thus,
the odds of one bad down day are somewhat diffused. In each case, the
average index level of the days in question is calculated to come up with
an ending point value.
Example: Average End
Like Long Term Point-to-Point designs, if
the average of the Average End falls below the level of the initial start
point, a “zero” is registered, and “minimum” guaranteed values
would be paid. If the averaged ending point is “above the line” of the
initial start point, a gain is registered.
Long Term
Point-to-Point
Here is a picture of the
typical Long Term Point-to-Point zones for counting gains.
Educational Illustration
(Typical “Long Term Point-to-Point zones for counting gains)
As this illustration makes
clear, it simply does not matter where the market has been, except on the
last day of the index term, when the Long Term Point-to-Point method
“matures”.
This illustration depicts both
“Long Term Point-to-Point” and “Average End” designs (where an
ending average substitutes for only one day - in each case the result is
the same - one final ending point). In this illustration, only the third
gain (Point A - above the line of the initial start point) counts. It is
the difference between the starting point and the ending point. (Of
course, “Ending Point B” would be a loss, resulting in a “zero”,
which means payment of guaranteed minimum values). The first gain and the
second gain are “excluded”. Also, you could make a case that the first
two of the three gains in this illustration are a retracing of the final
gain (looking back). One way or another, both of the first two gains
illustrated are “Zone #3” gains. There are also two instances of
“Zone #2” gains, where gains occur below the initial start point, but
again, they do not count.
The Average End Method is
exactly the same as the Long Term Point-to-Point method, except that the
end point will be an average of numbers taken over final weeks or months.
The design and the basic idea is highly similar variation.
HIGH WATER
ANNIVERSARY MARK, LOOK-BACK
Another index type is the “HIGH
WATER ANNIVERSARY MARK, LOOK-BACK” design. With this design, an Annual
Point-to-Point method is used to recognize and lock-in the annual index
values. At the end of the term or index period, the highest anniversary
value of a gain is used to compute the total index return for the
index term.
Example: High
Water Anniversary Mark, Look-Back
Pick the highest
anniversary mark above the initial start point (there is no annual
reset of start point), and that anniversary index value for that day is
the index value that is compared to the initial start point for the
purpose of determining gain for the full index term. In other words, at
the end of the term you “Look-Back” to pick the highest anniversary.
In the above example, the end of year 5 is the highest (high water)
anniversary point above the initial start point. Multiply the result of
that fifth anniversary point by the participation rate and a final index
return is derived.
There is a common
misconception relating to “High Water Mark” designs, as they are often
called. The misconception, is that “High Water Mark” means that the
highest point during the year is selected. Although it is theoretically
possible to do this, a significantly lower participation rate would be
required than current designs guarantee. That is why we refer to these
designs as “High Water Anniversary Mark” instead of “High Water
Mark”, so there is less possibility of misunderstanding the actual
method used, which, in fact, only counts days on the policy anniversary.
HIGH WATER
ANNIVERSARY MARK, LOOK-BACK
Logically, the odds of zone #1
gains occurring are about equal in the traditional ups and downs of the
market to the combined zone #2 and zone #3 gains. Here is a picture of the
typical “HIGH WATER ANNIVERSARY - LOOK-BACK” zones for counting
gains.
Educational Illustration
(Typical "High Water Anniversary Mark, Look-Back" zones
for counting gains)
In this classic example, the
High Water Anniversary - Look-back design potentially registers three
gains during its full term. However, only the highest of the three gains
above the initial start point (looking back) is the measure of the full
gain for the index term. Smaller retracing of gains of the type shown
(zone #3), and gains below the initial start point (zone #2) do not count
towards the final index result in this design method. The “High Water
Anniversary - Look Back” design does not count Zone #2 gains below the
line of the initial start point, or Zone #3 gains that retrace gains made
in previous years.
Typically, in today’s
interest rate environment (1997) High Water Anniversary Mark, Look-Back
designs have participation rates well below one hundred percent. Two of
the more well known designs are currently at 70% and 75%, respectively. As
a generalization, it would be fair to say that the High Water Anniversary
Mark, Look-Back design tends to be associated with participation rates at
the lower end of the participation rate spectrum.
Annual
Point-to-Point, with Annual Reset
This design in all its
variations, counts gains by the year, recognizes those gains, and locks
them in so that they are not lost in market down-turns. All three zones of
gain are counted.
Example:
Annual Point-to-Point, with Annual Reset
Year 1 gain +
Year 2 gain + Year 4 gain + Year 5 gain + Year 7 gain=Total Gain
Thus, you can see, that Annual
Point-to-Point designs of greater than one year generally have an annual
reset of the starting point feature. Gains are registered below the
initial starting point, which can be about half of the total possible
gains. Also, all annual gains are added or combined together for a term
total, as opposed to Long Term Point-to-Point, Average End, or High Water
Anniversary Mark, Look-Back designs, where ONLY ONE point is derived from
the index formula, and then a number and an effective annual yield are
calculated.
Annual
Point-to-Point with Annual Reset
Educational
Illustration
(Typical Annual Point-to-Point, with Reset, zone for
counting gains)
As you can see ALL UPWARD
MOVEMENT, whether above or below the line of the initial start point potentially
counts towards gains due to the presence of the annual reset. When you
consider gains below the line of the initial start point, (“Zone #2”)
as well as gains above the line that retrace zone #1 gains above the line
(“Zone #3”), there is a MAJOR potential difference in zones of
counting gains. Also, these gains, as recognized in each year, are combined
into a final total return, even if some of those gains are retracing
previous gains from previous years. For example, it is not entirely
improbable that gains between, for example, 500 and 550, could be
recognized, locked-in, and combined together two or even three times in
one index term. In summary, with Annual Resets, all three zones are
counted so that you get “correction protection” and “recovery
recognition”.
DEFINITIONS
As we begin describing basic design
types, here are a few practical working definitions that will be used.
CAP: A "cap" is a
maximum percentage limitation on the earnings as defined by the EIA index
formula. There are a several products, all with reset features, that have
“cap” rates between 12% and 15% annually. All “capped” EIAs we
have seen so far have the annual reset feature and the “combine all the
years’ gains” feature (versus one anniversary mark or one point to
determine the gain for the entire index term).
PARTICIPATION RATE: A percentage
amount, which may be guaranteed either by the year or for the policy index
term, which is multiplied times the percentage gain of the index formula.
For example, an index formula might yield an annual gain figure of 10%,
which is then multiplied by a participation rate of either 80% or, in
another EIA, 110%, to yield 8% and 11% respectively, in terms of the
calculation for that year.
STARTING POINT: or “index
starting point” is the index level on the starting date or issue date of
the EIA policy. It is the base-line number from which gains or losses are
measured the first year, where there is an annual reset feature, or for
the term of the index if there is no annual reset feature (eg. Annual
Point-to-Point or High Water Anniversary Mark, Look-Back designs).
ANNUAL RESET (of starting point):
The Annual Reset of starting point feature is a reestablishment of the
starting point for gain calculations, annually. This is largely of
importance if the market goes down and closes on a year below the initial
start point. This annual reset feature allows gains below the initial
starting point to be recognized and locked in for the customer, which does
not happen without a new lower start point. For example, a policy is
issued at an index level of 500, but the year closes at an index level of
400. The following year the index moves back to 490. With an annual reset,
the new annual start point was 400 (instead of 500) so gains from the
second year's move from 400 to 490 were recognized. Without a reset, no
gain occurs unless and until the index passes the 500 mark, potentially at
some time in later years. For example, if there were no reset feature, and
the index moved from 490 at the end of year two to 550 at the end of year
three, then the gain from 500 to 550 would be recognized. However the gain
from 490 to 500 during that same year would not be recognized since it
occurred below the line of the initial starting point (at issue) of 500.
INDEX PERIOD or TERM: This is the
length of time during which the owner has earnings linked to the index,
and it is the time frame for the final index gain calculation for the term
of that annuity contract. At the end of the term, various options are
offered, which differ by company.
RECOGNITION OF EARNINGS: By the
terms of the policy, a gain calculation is completed and noted or
recognized.
LOCK-IN OF EARNINGS: By the terms
of most contract designs, the gains are not only "recognized",
but they are guaranteed at that level, that is, they are
"locked-in". Locked-in earnings cannot be lost by subsequent
declines in the market index.
ZONE FOR COUNTING GAINS: There are
three potential zones for counting gains possible amongst the various
designs:
- Zone #1. gains above the initial
starting point,
- Zone #2. gains below the initial
starting point, and
- Zone #3. gains “retraced” over
zone #1 gains of earlier years of that index term, or gains excluded
by definition.
“AUTOMATIC ROLLOVER”: This is
an end of term provision in some, but not all EIAs. When this feature is
present, the EIA owner is limited to a relatively short period of time
(similar to a Certificate of Deposit) to decide whether or not to recommit
to the next term. Typically, this window of time is 30 to 60 days. If no
notification is received by the Home Office, the default option is to
enter another equity index term, with newly declared participation rates,
caps (if applicable), etc. and new surrender provisions. Normally, the new
term is the same as the first term.
One of the major areas of confusion among
agents is the calculation of various values within the EIA design.
Specifically, it is important that you understand that various
contractually defined values such as:
- Full Index Value,
- Surrender value during the term or at
maturity,
- Minimum Guaranteed Account Value,
- As well as values at death,
annuitization, nursing home or terminal illness values etc.
All these items may be, and usually are,
calculated independently of each other.
For example, Minimum Guaranteed Account
Values are often calculated based on 90% of premium, plus 3% interest.
Simultaneously, full index values are based on 100% of premium plus
potential defined gains from the index formula. Both exist simultaneously,
but do not directly relate to each other in this example. Your ability to
specifically understand EIA values depends on understanding this point.
Basic Types of EIA
Indexes
According to one industry authority, over
ninety (90) different designs of EIAs have been identified, although many
of these design possibilities will never be incorporated into a design
that is filed and brought to market. Among the basic design types already
in existence, Long Term Point-to-Point, High Water Anniversary Mark,
Look-Back, and Annual Point-to-Point with Annual Reset are the main types.
These types will be defined and explained in the balance of this article.
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