Equity Indexed Annuity Definition: Insurance Product

The equity index annuity is an insurance product that has an unfortunately large number of names that all relate to the same sort of product.

These annuities are also poorly understood in the press, and in most financial planning circles, so consequently they don’t receive the attention they should. They actually offer a relatively high yield for an extremely low level of risk.

Now, this definition is no Wikipedia entry, but we can help illustrate the meaning of these various terms, give some examples, and give you some glossary terms to help analyze the options available in the marketplace. Lets start with the basics.

 

Equity Indexed Annuity Definition: Financial Contract

An equity indexed annuity is a financial contract with an insurance company whereby the premium paid by the contract owner to the Company is invested by the Company in a low risk fixed income portfolio.

The income from the portfolio is used to purchase an Option for an equity position in a market index, such as the S+P or Dow Jones.

As it is only income, and not principal, that is used to purchase market option, the equity indexed annuity contract has a risk profile nearly identical to that of a fixed annuity- it is the credit quality of the underlying bond portfolio, but enhanced by the full faith and credit of the Insurance Company itself.

As such, to the Contract holder there is essentially no risk to principal at all.

However, due to the market option purchased, the low yield of the underlying bond portfolio is traded for the potential for market upside – the contract holder, depending on the terms of contract, will capture some portion of market appreciation and can end up with yields well in excess of the underlying bonds.

In the event of market declines, however, the option for participation may expire worthless- in that case, there may be no appreciation, however there is also no risk of loss of principal.

Furthermore, the Company issuing the contract may also offer future income stream guarantees that far outstrip other annuity offerings, because the underlying principal of the contract is so safely invested they can make future commitments with certainty, and without downside market exposure.

Now, apologies are offered if the definition above stretched beyond what Webster would normally offer. It is important to put the equity indexed annuity into perspective, with not just its features, but some of the benefits as well, to give a complete understanding

Why is the principal protection stronger and more secure than nearly any other investment option, in an equity indexed annuity? Well, lets look at just how an option works in the context of an equity indexed annuity.

A option is simply the right, but not the obligation, to purchase something in the future at a price you set today.

In the case of a market index option, you’re contracting with a counterparty to buy into the market in the future at a price you set today, and your counterparty is promising to sell its market position to you at a set price in the future, regardless of the actual market price.

Let’s use numbers in a fictional example here to make it easier to understand- remember, this is just an example, and not based on real market index or option prices. I will work in a glossary of terms as well to help:

Today a market index security tracking the S+P is trading at $1000 per share. You think a year from now, it will be trading at $1100. An option to buy 1 share of the market in 1 year at today’s value (strike price) of $1000 costs $20- so the market must be at least $1020 for you to be ‘in the money’.

In one year, the market is at $1100- you exercise your option, (Put) and buy at $1000, and resell immediately at 1100. On a $20 investment, you just made $80- a 400% gain.

The seller of the option had your $20 for a year, but carried risk up to the end, whereupon he was forced to sell (call) his market position for $1000 instead of the real value, of $1100. If the seller actually owned the share of the market, they hedged and made 2% for the $20 consideration, but gave up 8%.

If they didn’t actually hold the share, when you ‘called’ they would have to buy at $1100 and sell to you at $1000 to satisfy the contract, losing $80 on the trade.

However, if the market lost value, going from $1000 to $900 in the year, the option expires worthless, ‘out of the money’. You lose the $20, and the seller made $20.
If they actually owned the share in the market, their loss of 10% is mitigated (hedged) to 8%- if they simply carried the risk, the made $20 with nothing at risk.

So in a nutshell, and leaving out lots of complexities, this is how an option works. But to understand how it works in the context of an equity indexed annuity, we need to go in a little deeper.

In the example above, if you owned the market directly- such as thru a mutual fund or direct share ownership- your $1000 investment would be worth $1100 after the year- a 10% gain.

But, in an equity indexed annuity, you actually own a portfolio of very safe bonds AND you have the insurance company managing and guaranteeing the yield. Let’s assume this is 4% annual yield, or $40 income over the course of a year. This is essentially the structure of fixed annuity offers, by the way, but we need to stay on topic here….

In the Equity Indexed Annuity, your $1000 bond portfolio will earn $40 virtually guaranteed- secured both by the underlying corporate credits, and by the reserves and financial strength of the insurance company.

If fact, it’s not really accurate to call it ‘your’ bond portfolio at this point, as your funds join billions of dollars professionally managed by the insurance company for long term stability. This is what insurance companies have done, and done well, for hundreds of years.

Now there are costs for administering your money and offering the guarantee to your principal- let’s assume this is $20. So after expenses the company has another $20 to invest- and they purchase an option, with a strike price of $1000 for 1 year in the future, and it costs $20.

Your 4% yield on rock solid principal has been used up by the 1) administrative costs and 2) the option consideration.
Now, the market goes up as described above- the option yields $80 gain- this is a 400% gain on the investment ($20) and an 8% gain on the underlying principal, but with basically no risk.

Subject to your participation rates (which is another topic covered fully in The Annuity Report (www.AnnuityStraightTalk.com) you will be credited with some portion of this $80 gain, and that gain can be reinvested, Tax deferred, into the bond and option market next year.

Annuity Definition (Explained)

Equity Indexed Annuity Definition: Main Benefits

What’s the point of that long example above? Downside protection- let’s say the market goes to $900.

Your $1000 is invested in ultra-safe bonds, yielding 4%- the $40 is used for $20 of admin costs, and the purchase of an option for $20. You are left at the end of the year with $1000, invested in bonds- 0% appreciation, but no loss.

If you invested that $1000 directly in the market, you would be left at the end of the year with $900.
Safety, security, upside participation, and no downside risk should be the REAL Equity Indexed Annuity definition!

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