Should index annuities be part of your safety-minded client's portfolio?

These annuities pay a rate of interest based on a percentage of the gain or loss in a market index, such as the S&P 500, but they also offer downside principal protection. Often, there also is a guaranteed floor of about 1%.

Apparently, cautious people, who typically invest in CDs, fixed annuities and bonds, are investing in this product at a fast clip. Index annuities set a new record high in the third quarter of 2010, with sales totaling nearly $9 billion, up 16% over the third quarter of 2009, according to LIMRA, Windsor, Conn. The attraction: Unlike variable annuities, they generally have no market risk, and they stand to pay higher returns than fixed annuities.

Sales of index annuities were estimated by LIMRA to hit $33 billion by year-end 2010, up from $29 billion in 2009. Forty-one percent of fixed annuities sold in 2010 were deferred annuities linked to the market. And 91% of all index annuities were sold by independent broker-dealers, according to Beacon Research, Evanston, Ill.

Over the past five years ending in November 2010, the average index annuity credited a 3.9% annualized interest rate. By contrast, one-year CDs yielded 2.8% annually and five-year CDs yielded 3.8%, reports Advantage Compendium, St. Louis. By contrast, the S&P 500 index grew at just a 0.65% annual rate.

"It is not surprising that sales of index annuities had a record quarter," says Joseph Montminy, assistant vice president for LIMRA's annuity research. "This is the ideal market for index annuities because there is lots of volatility in the equity markets coupled with low credited rates and declining interest rate spreads on traditional fixed annuities."

Judith Alexander, analyst with Beacon Research, says guaranteed lifetime withdrawal benefits and premium bonuses are driving demand for the product. "The main emphasis continued to be what was guaranteed, including premium and income account bonuses, income account roll-up rates, and guaranteed minimum interest rates above 0%," she says.

Insurance company equity index annuity portfolios are made up of target maturity investment-grade bonds and equity index options, says Dr. Geoffrey VanderPal, chief investment officer of Skyline Capital Management, Austin, Texas. The majority of policyholder money is invested in bonds. A discounted amount of the present value of the bond portfolios is put into a customized equity index option for the majority of the period.

As the bonds mature in the underlying portfolio, the matured bond value provides the principal protection, and the minimum guaranteed contract return is based upon the portion of the dividend generated, he adds.

Today, most index annuities pay policyholders a minimum guaranteed floating yearly rate based on Treasurys that is 1% to 3% on 87.5% of the premium paid into the contract, says Jack Marrion, president of Advantage Compendium. Due to low interest rates, that guaranteed floor has declined to about 1% from as high as 2% to 3% of the total premium several years ago.