Equity-Indexed Annuities, Income Riders & Crediting Methods

finance1What is an Annuity? The word annuity has its origins in a Latin term that means “annual.” Today, an annuity is an investment product sold by insurance companies. Annuities can be purchased through a series of contributions or in one lump sum. The money put into the annuity contract is allowed to grow for a period of time. Then, at a future date, the contract is annuitized and annuity begins paying an income through periodic payments over a specified period of time or for a lifetime. The interest or growth in a “deferred” annuity is not taxed until the annuity is actually paid and received by the owner.

Equity-Indexed Annuity
An equity-indexed annuity is a type of annuity that grows and earns interest based on a formula related to a specific stock market index.

EIA Common Terminology
Although EIA contracts share the same objectives, they can vary a great deal. Here a important terms to help you understand your options:
Term: The length of time of a penalty period or the time an investor has the option to renew. Typically a term is a period of three to seven years.
Participation rate: Also known as the index rate, the percentage rate reveals how much a contract will grow. For example: “75% of the Standard and Poor’s index increase for the calendar year” means that if the Standard and Poor’s 500 index increases 10% for the year, the contract receives a 7.5% increase in credit. Often, the rate is 100%. The insurance company can change the participation rate.
Cap rate: The annual maximum increase in percentage allowed. For example, if the contract’s cap rate is 7% and the chosen market index increases 15%,
then the increase is limited to 7%. The insurance company can change the cap rate and some contracts do not have a cap rate.
Floor: The minimum guaranteed amount credited to the contract, typically in the two to three percent range.
Reference or contract value: The amount the investor is entitled to. For example, the greater of the current account value less any remaining surrender charges.
Anniversary date: The date that marks the beginning of the term used to measure how much the annuity contract has grown.
Other factors:
Guaranteed death benefits:
If annuitant (contract owner) dies before the annuity begins paying, some contracts pay the named beneficiary the greater of the investment (less withdrawals) or the contract value on the death date.
Regulation: Even though the stock market influences the EIA, the laws that regulate securities, such as stocks and bonds, do not currently apply to an EIA. This may change on January 12, 2011. Rule 151A, if it stays alive, would bring EIAs within the influence of federal security laws. This would mean that a prospectus explaining how annuity contract works, detailing the risks, and lists all charges that may be levied must be provide to the buyer. And only those who have both a securities and insurance licenses may sell EIAs.
Contract fees and charges: Even though many EIA’s do not have any fees associated with them, some contracts may be subject to fees and charges. Make sure you know what you are buying. These fees include:

  • administrative fees that cover the insurer’s basic expenses,
  • mortality risk charges to cover the cost of any guaranteed death benefit provisions,
  • And surrender charges for withdrawals in excess of a certain amount or if the contract is completely surrendered.

Surrender charges can range from 0 to 15% and decline over time. Surrender charges result in a redemption that’s less than the principal amount invested.

Taxes on Annuity Payments
How payments from an annuity may be taxed varies, depending on the life cycle of the annuity. Based on federal law, generally the following rules may apply:
Before annuitization: Any funds withdrawn from an annuity contract prior to annuitization (before payments begin) are considered to be from interest or other growth. These earnings are taxable just like ordinary income. If the annuity owner is under age 59 ½ at the time of withdrawal, the earnings are also subject to a 10% IRS penalty. If earnings are completely withdrawn and the payments are made from the owner’s initial investment, the withdrawal is treated as recovery of capital and tax free.
Changes to the annuity contract, including loans, collateral assignments, and changes in ownership may be taxed.
After annuitization: Annuity payments are treated a part earnings and part capital return. The earnings portion is taxable. Once the owner has completely recovered his or her investment, all remaining payments are fully taxable as income.
Estate taxes: Amounts paid to a beneficiary after an owner’s death are included in the owner’s gross estate. If the owner of a life-only annuity contract dies, no payments are due and nothing is includable in the estate.
Income in respect of a decedent: Payments received by the beneficiary are still subject to income tax. However, the beneficiary may be eligible for a federal income tax deduction for a portion of the estate tax paid.

INCOME RIDER ILLUSTRATION (HYPOTHETICAL)

Initial Premium $100,000 Guaranteed Income: 8%3

Bonus $10,0001

Income Rider Cost -50 Basis Points ($500) Annually

INCOME

Single Life

Guaranteed

CONTRACT

ONLY

Payout

Lifetime

"REAL"

BUCKET 8%

Percentage

Payout

Year

AGE

BUCKET 2

COMPOUNDED3

Based on Age

Amount

1

65

$115,090

$118,800

5%

$5,940

2

66

$125,080

$128,304

5%

$6,415

3

67

$125,080

$138,568

5%

$6,928

4

68

$125,080

$149,654

5%

$7,483

5

69

$134,091

$161,626

5%

$8,081

6

70

$140,930

$174,556

6%

$10,473

7

71

$145,749

$188,521

6%

$11,311

8

72

$149,160

$203,602

6%

$12,216

9

73

$156,857

$219,891

6%

$13,193

10

74

$156,857

$237,482

6%

$14,249

11

75

$158,040

$256,480

7%

$17,954

Notes:
1) Day 1 contract value is $110,000 (Bonus may be subject to a vesting schedule if early withdrawal).
2) Full contract value at death is taken from the “real” bucket. Nursing home and critical illness penalty free withdrawal is also taken from the contract value (the “real bucket”) as is the 10% annual penalty free withdrawl.
3) Income value (“income only bucket”) is a separate account and is credited by the company with 8% per year until income is desired (i.e., until you tell the company that you want to start receiving income). When income is desired (may require a 1 year deferral period depending on the carrier) the company will look to this value (or whichever is higher between the “real” value and the “income only” value) and pay out a percentage of that value for life. The percentage payout is based on age (e.g., 5% of the “income only” account for someone age 65). This percentage changes from carrier to carrier. Once established the income does not change (except certain policies where an increasing annual lifetime income amount is available).

SUMMARY: An Equity Indexed Annuity with an Income Rider is a contract between you and the insurance company which provides: 1) Guaranteed return of principal, 2) Returns linked to an index (subject to a cap), 3) Credited gains cannot be lost, 4) Guaranteed minimum interest, 5) Liquidity features (nursing home, critical illness & 10% annual withdrawal), 6) Taxes not due until withdrawal, 7) Avoidance of Probate, 8) Protection from creditors, 9) No annual fees (other than the cost of the rider depending on the carrier) and 10) guaranteed income you (or you and your spouse) cannot outlive.

Equity Indexed Annuity Crediting Methods

Funds can be allocated between the different crediting methods and each year the allocation can be changed. Most EIA’s allow for one or a combination of different indexes to be used such as S&P 500, Nasdaq-100, FTSE 100 etc.

1) Fixed Account: Usually between 2.5% -3.5%

Fixed account crediting is good in years when the market will decline and guaranteed growth is desired.

2) Annual Point to Point with a Cap (assume 6.5%). Take the difference between the anniversary of the contract value of the index used and the end of the contract year value and apply the cap (if applicable). For example, if the index (say S&P) goes up 12% for the year of the contract, the account would get 6.5% (the cap). If the S&P went up 5% the account would get 5% and if the market went down 15% the account would stay even.

Annual Point to Point crediting is good in years when there is modest gains in the market.

3) Monthly Sum (also called Monthly Point to Point) with a monthly cap (assume 2.5%). Take the difference between the beginning of the month value of the index used and apply the monthly cap (if applicable). For example, if in the first month of the contract the S&P went up 2.75% the account would get 2.5% (the cap). If in the second month of the contract the market went up 2.10% the account would get 2.10 etc. There is no limit on negative returns each month (except for the fact that at the end of the year you can never lose money so if the crediting method yields a negative the account would stay even) so if the index would go down 3.2% in month 3 and down 3.5% in month 4, the contract would be (2.5%+2.1%-3.2%-3.5%)= negative 2.1. Hypothetically, if the S&P went up 2.5% or more each month the account would make 30% (2.5% x 12).

Monthly Sum (Monthly Point to Point) crediting is good when there are consistent gains in the market.

4) Monthly Average with a spread (assume 3%). Monthly values are added for the year and divided by 12 to get the average index value. With that value the percent gain or loss will be computed. If there is a percentage gain then the spread is subtracted from the gain to determine the credited interest rate. To illustrate:

Step 1: Note the market value as of the date of the contract. For example 970.43
Step 2: Add up all end of month values and divide by 12. For example 13,054.27/12=1087.86
Step 3: Determine gain or loss: 1087.86-970.42=117.43 points or a 12.10% gain.
Step 4: Subtract the 3% spread to determine credited amount (12.10%-3%)= 9.10%

The Monthly Average crediting method is good when the index is volatile.

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