Clearing the Confusion Between Variable Annuities and EIA’s

The SEC is presently reviewing the classification status of EIA’s, in all probability, due to the constant clamoring by former NASD chairman Robert Glauber that the identity of them is unclear to him. For those of us in the insurance industry, we do not find the pure insurance nature of indexed annuities difficult to understand nor accept. While there are a few features of EIA’s that are routinely mentioned in detractor’s arguments as they attempt to indicate that these insurance products could be mistaken as securities, it is the misstatements of these features that only confuse the nature of an otherwise very clear insurance contract. One of the tactics used by detractors of indexed annuities, and confused financial journalists, is to describe the features of variable annuities, a hybrid security and insurance product, but refer to indexed annuities, a guaranteed insurance contract.

To make the differences between these products easier to understand, let me first clarify the concept of a variable annuity. The defining features about a variable annuity, which causes it to be regulated as a security, is because of two very important distinctions from its pure insurance cousin. In a variable insurance product, the client assumes ALL of the investment risk, rather than the insurance company. This is why the insurance company is required to put all client funds for variable products in a “separate” account from their general fund. There is no guarantee that a variable annuity holder will earn any return on their investment, their original premiums are not guaranteed, and the value of their account can and does go down with the loss of value of the underlying investments. It is possible for a variable annuity owner to lose some, or even all of their original investment. Within a variable contract, the client chooses specifically how their funds will be allocated from a set of mutual fund-like investments options offered within the variable product.

The few guarantees included in a variable product do not stem from the securities side, but from the insurance side and are provided by a deduction of expense charges from the client’s assets within the separate account, and are charged periodically, regardless of how the investment is performing. It is this catch that has caused so many variable policies to risk lapsing, when their investment losses have reduced the account value to a point where it could no longer pay the insurance premiums for the guaranteed benefits. If this happens, the owner must either pay additional premiums to continue the policy, or the policy will lapse.

Quite different from a variable annuity, in an indexed annuity, the client does not incur ANY investment risk whatsoever. In fact, not only is their initial principal guaranteed, but in most policies, there is a minimum guaranteed rate of interest that is credited over the contract period. In the case of an EIA, unlike a variable product or a securities product, the client does not tell the insurance company how to invest their premium dollars. It is totally up to the insurance company to figure out how to provide the contractual guarantees of principal and interest.

Indexed annuities do not have any fees deducted from active accounts. All of the client’s premium funds are credited to the policy at issue, and no expenses are deducted from that account in the future. Agent sales commissions, company expenses, and profits are all earned by using arbitrage, the same techniques banks use to make money with client deposits. Premiums received for the purchase of indexed annuities are deposited in the insurance company’s general accounts and are invested by the insurance company, at their discretion; in a way that allows them to financially provide all of the contractually obligated policy benefits, pay their expenses, and make a profit for themselves.

Client premium deposits are 100% guaranteed, and interest earnings, once credited, in most cases are “locked in,” and the account can never go down unless the client takes money out. Since an indexed annuity is a contract, there are obligations and responsibilities stated in the policy for both parties to the contract. The insurance company agrees to provide the stated benefits over the policy period, and the client agrees to leave their premiums deposited with the company for a set period of time.

The insurance company does not have any provisions in the contract for breaking or canceling the contract and must provide all of the contracted benefits as agreed for the entire contract term. But in deference to the client, the only provision that is required of them, in order to enter this contract, is the deposit of premiums; and, if the client, for any reason, does not want to continue their part of the agreement, there is a provision in the contract for them to alter, or completely break the contract by way of partial or full surrender.

But like every contract, there is a penalty for such action, and in an indexed annuity that penalty is called a surrender charge. This penalty is never enforced and the fees are never charged until or unless the client withdrawals exceed a contractually allowed annual amount during the surrender period. Surrender charges are clearly stated in the contract, and a schedule of guaranteed surrender values for any future year is provided. This puts the client in complete control of how and when they access their money, and whether or not they will ever incur any surrender charges.