Introduced in the early 1990s andvirtually ignored during the run-upin equity values over the pastdecade, equity-indexed annuities (EIAs)have attracted considerable attentionfrom baby boomers. EIA benefitsinclude tax-advantaged participation instock market performance, returnslinked to index increases, protectionagainst market losses, full protection ofprincipal, minimum rates of interestreturns, and tax deferral of earnings andliquidity. The tradeoff is that physician-investorsreceive less than full indexmarket gains. How much less dependson several factors, including the EIA'sparticipation rate, spread, growth caps,and calculation method. Insurancecompanies need to cover the guaranteesand volatility of the underlying index.Like other annuities, EIA gains are tax-deferreduntil withdrawal. But unlikemunicipal bonds, interest remaining inan EIA is not included in Social Securitycomputations, and it is not subject toprobate if paid to a beneficiary. In addition,EIAs offer protection from creditorsin most states.
An EIA's growth can fluctuate wildly,depending on the method used to calculateindex performance. There are fourbasic methods of calculation:
•Annual reset. The investmentreturn is determined each year by comparingthe index value at the end of thecontract year with the index value at thestart of the contract year. The interest iscredited to the value of the annuity eachyear during the term.
•High-water mark. The investmentreturn is calculated by marking theindex value at various points during thecrediting period, usually the anniversaryof the date of purchase.
•Averaging. The average indexvalue is used rather than the value of theindex on a specific date. It can occur atany point during the term of the annuity.
•Point-to-point. Investment returnis based on the difference between theindex value at the end of the term andthe index value at the start of the term.
Product sponsors like to promote amonthly point-to-point method becauseit makes it easier to buy and sell optionsand also provides more leeway. Initially,it might appear that making headwaywould be difficult for physician-investorsusing this method, given that 1or 2 down months in an otherwise goodyear could play havoc with portfolioperformance. However, the 10-year dataindicate otherwise.
In addition to participation rates andcalculation methods, EIAs also containsignificant differences in minimum interestguarantees, issuer strength, spreads,earning caps, surrender charges, and distributionrestrictions, all of which canhave a noteworthy impact on investmentreturns. One of the largest EIAproviders offers a tempting upfrontbonus payment. But a closer examinationreveals stringent withdrawaloptions, including a provision thatrequires investors to annuitize theirfunds at the end of the contract period.This means they can't receive theirmoney in a lump sum, as funds can onlybe withdrawn in predetermined portionsover a set period of time, typically at afixed rate that is less than competitive.
In addition, EIA withdrawals beforeage 59½are subject to a 10% penalty.They're intended as a long-term strategy,which fits with most boomer investmentand retirement objectives. EvenEIA opponents admit the product canbe appropriate for boomer-aged investors.Physician-investors in their 50sand 60s making their final investmentpush to retirement, whose investmenttime horizon might be 5 to 10 years,may be a good fit for this. Since there islittle time to earn back any investmentmistakes, new investments and therepositioning of equity-invested assetsmight now be prudently invested withan eye on conservation.EIAs can be an ideal choice for preservingsafe money, but physician-investorsshould research the productbefore investing.
Ori W. Pagovich is a managing partner of
Gotham Financial Services in New York. He
welcomes questions or comments at 212-340-1050 or 212-253-4020 (fax).