Interest Calculation

The determination of the indexing method and the selection of the index against which that method is applied are only the beginning of the process. The next step is to apply the rate of participation set in the EIA contract. This rate establishes how much of the increase in the index will be used in calculating the interest earned by the EIA. The participation rate may be set for the term of the EIA contract or may be adjustable at specified dates. The rate may range from 100% in some contracts to as little as 50% of the actual index increase in others. Although the participation rate varies, it is important to be aware that other features of the EIA contract may affect the amount of interest credited to the EIA.

The interest rate also may be determined based on the application of a spread or administrative fee to the actual increase in the index. Such a provision may be in lieu of using a participation rate or applied in addition to the participation rate. Another factor that may apply to the interest calculation is an EIA provision setting a maximum on the amount of interest that may be earned in any year. This interest cap is more commonly found in EIA contracts with greater rates of participation or more generous interest crediting provisions. Quite apart from the rate of participation, spreads and caps, it is useful to understand that the index return typically does not include the dividends paid on the component securities in the index. This means that the positive impact of dividends may not be recognized in the calculation or crediting of interest to the EIA owner.

Depending on the indexing method used, interest may be credited on an annual basis (e.g., annual reset) or may not be credited until the maturity date of the contract (e.g., high water mark or point to point). This "vesting" of interest credits may have an effect on clients who seek to make a withdrawal from or termination of the contract prior to the end of the term. With EIA contract terms ranging from an immediate annuity to terms up to fifteen years, timing may be important. An additional concern related to the timing of interest credits is the compounding of interest. Some EIA contracts pay simple interest during the term while others may pay interest on the interest previously earned.

Finally, although there are many approaches to determining the amount of interest to be credited, it is important to remember that the EIA also limits downside risk. The EIA typically provides that there will be no negative interest - so that even if the market falls and the measuring index declines, the client's annuity will not lose value. An EIA contract may specify a minimum guaranteed return, above and beyond the guarantee of no loss of value in the annuity. Many sources refer to this protection in terms of a guarantee of 3% interest on 90% of the client's premium payment or contribution over the life of the contract.² Thus, even if the interest calculated using a combination of the methods discussed above is insubstantial, the minimum guaranteed return may be applied where it exceeds actual returns. Of course, it is important to be aware that this guarantee typically is based on something less than 100% of the contract, thus raising the potential for a loss in the contract under adverse market conditions.

Costs and Fees

The provision of the guarantees and features of the EIA naturally come at a cost to the purchaser. Although there may be no annual fees or front end load broken out for the contract, the issuing insurance company includes costs in setting the structure for the minimum guarantees. Thus, the selected indexing method, participation rate, caps, margins or spreads and other factors will all play a role in determining what the insurance company retains and what is shared with client purchasers.

As in the case of many annuities, EIA surrender charges are an important consideration for any client considering their purchase. The EIA contract typically provides for significant surrender charges and/or penalties in the early years of the contract; these charges may be reflected as a percentage of the amount withdrawn, as a stated dollar amount or as a reduction in the interest credited. In some cases, an early withdrawal will result in no interest being credited to the annuity, regardless of any increases in the underlying index.

It is also worth noting that insurance companies will pay commissions on the sale of EIA contracts and that these contracts are not the same as ownership of index funds, ETFs or other securities. A recent report stated that in the second quarter of 2006, commissions paid on EIA contracts averaged just over eight percent of premium.³ Of course, the actual commissions will vary with insurance companies and particular contracts.

Advantages of the EIA

The EIA was developed to provide protection against the risk inherent in the markets - and by extension in variable annuities - through its guarantees against a loss in value and in offering minimum returns. This guarantee is enhanced by the opportunity to realize some upside potential not available in fixed annuities while retaining downside protection. It is central to the evaluation of the EIA to recognize that it is not intended to outperform the market. In fact, it is precisely because the EIA is intended to reduce risk that we recognize a trade off in terms of the market's potential upside performance as reflected by participation rates, interest caps, spread and many other factors. The purchaser of the EIA is not taking the risk inherent in striving for the full upside potential and so will not get the reward.

Who might benefit from an EIA? Based on the characteristics of the EIA, there are several factors which suggest a client could potentially find an EIA attractive. These factors include:

Disadvantages of the EIA

As in the case of many strategies available to our clients, the EIA is not for everyone. There are three major concerns with the EIA, and several minor ones. The first area of concern is the cost of the trade off for protection against downside risk offered by the EIA. In most cases, the client purchasing an EIA must give up dividends and much upside potential for a minimal guarantee of return and contract value. Second, the broad variation among EIA contracts and combinations of features offered to clients may be problematic. Any time clients are confused or uncertain about what it is they are purchasing there is a potential for problems for both client and advisor. This highlights an opportunity for advisors to help their clients in evaluating whether a particular EIA may be useful for the client. Finally, although most EIA contracts are not considered to be securities, the SEC and NASD have taken interest in the EIA and how it is marketed and this interest is likely to play a continuing role, affecting clients, advisors and insurance companies.⁴

The specific disadvantages of the EIA are substantially the mirror image of the factors covered in the preceding discussion of advantages. Clearly, a client who desires greater upside participation in the markets will find the EIA unduly constraining. Such a client should instead invest directly in equities and other securities, assuming the client's risk tolerance and other factors support such a decision. Significant disadvantages exist for a client with liquidity issues. If the client finds it necessary to withdraw some or all of the funds in an EIA, surrender or withdrawal charges and potential forfeiture of interest may result in a substantial loss. Further, early withdrawals from an EIA may result in the imposition of penalties as well as income tax liability. Another potential disadvantage to clients could occur where markets perform badly over the contract term since the guarantees may not be sufficient to protect all of a client's contributions, as where the guarantee is for less than 100% of contributions.

What else should the client and advisor consider in connection with evaluating the EIA? Compare the terms and features of the EIA to other fixed income alternatives. If tax deferral is not controlling, such alternatives may be very competitive, especially over the short term. When evaluating the guaranteed minimum return, inflation might be worth incorporating in the analysis. Recall that many EIA contracts offer a guaranteed return of 3% on 90% of the contributions. If inflation is at or near 3%, then the guarantee might be considered essentially a hedge against inflation.

Where a client is not already maximizing other sources of tax deferral - such as contributions to a qualified retirement plan account - it may be preferable to direct contributions there instead of an EIA. This is because the contributions are themselves tax deferred unlike the contributions to the EIA. The earnings equities experience are often taxed at favorable long term capital gains rates while interest credited to the EIA - and growth in qualified retirement plan accounts and other tax deferred vehicles - will be taxed at higher ordinary income rates.

Another rule of thumb that may be worthwhile to consider when evaluating the EIA (or other strategies) is to avoid "putting all the eggs in one basket." This may be particularly important where the client has limited liquidity since that is one problem we do not want to exacerbate by placing too much where it is not readily available to the client without cost or penalty.

A final factor to consider in evaluating the EIA is that, just like all annuity and insurance products, the guarantees offered are dependent on the continued financial health of the insurance company. A careful evaluation of an EIA should include verification of the rating of the issuer to ensure that risk is minimal.

Illustrating the EIA

Modeling the EIA in the context of a client's financial goal package is not a simple exercise. While carrying aspects of a fixed income investment, the EIA also involves uncertainty as to the amount of interest credited over the term of the contract. No asset class is an adequate proxy for this combination. One approach would be to show the client's contribution to the EIA as a current non-investment holding, reflecting the value of the EIA in the client's current net worth. Then, at the contract maturity date, assuming no renewal, a cash inflow would be entered representing either the grown value of the contract or the anticipated distributions to the client if the contract is annuitized. In the former case, the best practice would be to enter the guaranteed minimum account value and interest amount credited to avoid overstating the uncertain future value.

Summary

The EIA is an interesting hybrid that may appeal to some clients. Advisors who rigorously qualify their clients before recommending the EIA will be doing their clients and themselves a valuable service. This qualification process should include addressing the concerns outlined above in the discussions of the advantages and disadvantages of the EIA. A client who understands the limitations and benefits of the EIA will be able to make an informed decision whether to proceed and in appropriate cases may benefit. Of course, there are a number of alternatives to the EIA if a client seeks to control against downside risk and both advisor and client are willing to do the work necessary to attain that end. In a future article, we will take a closer look at the likelihood the minimum guarantees offered by the EIA will in fact pay off and the trade off a client makes when purchasing the EIA or chooses an alternative approach.

Understanding the benefits and detriments of the EIA. This is the future of financial advising.