Hedging & EIAs

Hedging is a way of reducing some of the risk involved in holding a position or taking an action that you are not absolutely certain is the best you. There are many different risks against which one can hedge and many different methods of hedging. When someone mentions hedging, think of insurance. A hedge is just a way of insuring against uncertainty. 

Consider a simple case, the S&P 500 stock market. Much of the risk in holding a diversified portfolio of S&P 500 stocks is market risk; that is, if the market falls sharply, a diversified portfolio will loose value. So if you think the stock market in general is overpriced, you may want to hedge your position in the market. There are many ways of hedging against market risk. Some people who are active in the market buy options on the market in order to protect themselves against general market declines.

What if you are not active in the market, but you do not want to be left behind either?  How can you benefit from the potential advances in the market without exposing your principal to the downside market risks?  If a person desires the potential for a higher gain than they might achieve with other savings vehicles without market risk to their principal, they should consider an equity indexed annuity.

What is an Equity Indexed Annuity?

An Equity Indexed Annuity (EIA) is a new type of fixed annuity.  An EIA offers all the safety and guarantees of a traditional fixed annuity, but goes a step further.

In addition to the benefits of a traditional annuity, the EIA offers the potential for enhanced value through participation in equity market performance.  This is usually accomplished by linking (indexing) the credited rate to an equity index, such as the S&P 500 Composite Stock Index.

Although the credited rate is linked to stock market performance, safety of principal is assured with an EIA, as a decline in the market will not reduce policy values.  The idea is to offer higher performance without exposing principal to market risk.  At the same time, the EIA policyholder shares in market gains, but does not realize 100% of the gain.  An EIA policyholder trades 100% of the market risk in order to have a share of the gain.

Features and Benefits

Equity Indexed Annuities offer all the features of traditional fixed annuities plus the ability to participate in market gains:

• Guarantee return of principle (less any applicable charges)
• Safety and guarantees of principal and earnings
• Death benefits free of probate
• Tax deferral on accumulations
• Lifetime retirement income options and death benefits
• Long-term accumulation
• Minimum guaranteed surrender values
• Access to funds through free withdrawals
• Surrender charges apply in most cases on early withdrawals
• Interest rates used to credit the policy are based on the performance of the market index used in the policy subject to other policy provisions.  Better performance can result in a higher interest rate.  Negative performance can result in a zero interest rate.

Guaranteed Values

The Equity Indexed Annuity is a fixed annuity because it offers guaranteed values regardless of how the stock market performs.  The insurance company uses earnings from fixed investment products, such as bonds, to support policy guarantees. 

Hedging the Index

The Equity Indexed Annuity credits interest to the policyholder based on the performance of an index of equities such as the S&P 500. The insurance company hedges the index by purchasing options on the market to fund the future obligations to its EIA policyholders.  The insurance company pays a fee for the right to profit from a rise in the market, and shares a portion of that profit to fund interest credited to its EIA policyholders.  If the market goes up, the policyholder can benefit from the higher interest rates credited.  If the market stays the same or goes down, the policyholder can benefit from the minimum guaranteed interest rate.  Though hedging, the insurance company protects itself and its policyholders from the unpredictable direction of the market.

Conclusion

An equity Indexed Annuity policy can be an excellent vehicle for someone seeking a better return and enhanced value.  Those who take a long-term view often reap the greatest rewards.  So it is with an Equity Indexed Annuity.  An EIA is not a put-and-take account.  An EIA may be suitable for those who can leave their funds in the policy for a period of five to 10 years or more.  An EIA may not be suitable for those who have a need to take their funds out earlier.