Run, run, run from the investments known as equity-indexed annuities (EIA). All too often, they’re sold deceptively, to people who don’t understand how they work, by salespeople who are making a killing in commissions. Attorney generals in several states have brought and settled class-action lawsuits against companies that sell EIAs. FINRA, which regulates securities firms, has put out an investor alert (www.finra.org/investors). They’re a major source of consumer complaints.
EIAs are contracts with insurance companies. They’re sold to people— usually people over 60 years old—who normally buy interest rate investments such as fixed annuities or bank CDs. These conservative investors would love to earn higher, stock market returns over the long term but wouldn’t dream of putting any money at risk.
An indexed annuity is their grail. It combines the potential for stock market gains with little risk of principal loss. Every year, the insurance company credits you with interest, tax-deferred, based on a complex formula loosely connected with how the stock market performs. If the market rises over a specified period of time, you make some money. If it doesn’t, you’re guaranteed some sort of minimal return. All profit, no loss (you think). How could anyone resist? Greedy salespeople may encourage new retirees to roll their entire 401(k) into the EIA.
But although the concept can be stated simply, the investment is complex, and salespeople may withhold certain critical information. For example, you’ll probably have to hold the investment for 5 to 16 years—a problem if you’re 75 and were sold a 16-year product. Your “minimum guaranteed return” is typically figured only on part of your investment, so you could still lose money overall. You face large penalties for withdrawing early. If you die before the EIA matures, your beneficiaries may get less than you put in. The fees are huge. Salespeople may show you, on paper, how super these annuities perform over periods when stocks do well, while glossing over how little you’ll earn (or your risk of loss) if stocks decline.
The Securities and Exchange Commission has ordered stronger regulations for equity-indexed annuities issued on or after January 12, 2011. They will require more disclosure to consumers and supposedly provide you with better protection against deceptive sales. Will that solve the problem? No. Deceptive selling won’t go away, and when did “disclosure” turn a bad investment into a good one?
EIAs sell themselves as a free lunch. You have nothing to lose, thanks to that minimum guarantee, and everything to gain if stocks go up. But just because EIAs work out sometimes doesn’t make them a good idea. You give up too much inflexibility in older age, pay a ton, will earn less than you imagine in a rising market, and could still lose money. In many tests, equity-indexed annuities don’t perform any better than fixed annuities, due to the EIA’s higher cost.
If you know all these things and decide to listen to the sales pitch anyway, here’s what to ask:
“If I put my hard earned money into this investment, how long do I have to keep it there?”
Generally, you commit to holding for 5 to 16 years. Don’t even think of investing money that you might need over that period. (There are 1- to 3-year EIAs, which are a roll of the dice as far as the stock market is concerned.)
What do I earn over that time period?
Even if you write it down, you’ll still be confused. You’re typically credited with anywhere from 60 to 100 percent of the price gain of the S&P 500 (or some other average). For example, if the market rises by 8 percent and your annuity gives you 75 percent of the gain, your contract will earn 6 percent. Insurers can generally change that percentage from year to year, so you’re never sure how much you’ll get. If the contract isn’t profitable enough, they’ll reduce the amount of gain they credit to customer accounts.
Don’t imagine that a company that credits you with 100 percent of the year’s market gain is giving you a better deal than one that credits you with less. That “100 percent” is a sales tool. They’ll make up the money somewhere else.
There may also be a cap on what you’re allowed to earn in a year when the stock market soars. The company can usually change the cap whenever it wants.
“Am I credited with the dividends that the market pays?”
Answer: No. Losing dividends is significant. Currently, they’re averaging around 3.5 percent. Since 1926, they’ve accounted for 43 percent of the S&P’s compounded gains. Losing dividends is big, in dollar terms.
You’re often offered a signing bonus of 5 percent, sometimes up to 16 percent. That’s a sure sign of a high-cost, low-yield, anticonsumer annuity. You’ll more than pay for your “bonus” in reduced returns.
At the end of the term, how does the insurer figure your gain?
This is confusing too. Some companies use the market price on the day the annuity matures. Some look at each policy anniversary date and pick the highest one. Some average the price over your annuity’s final 12 months. Some credit a portion of each year’s market gains, if any. Some investment companies give you 100 percent of the gain but deduct 1 percent for expenses. And there are other systems available from the same company and from other companies. Unfortunately, there’s no way of knowing in advance which one will pay the most. Everything depends on how the market performs over your particular holding period.
What if stock prices drop?
You’ll be credited with zero that year. If stock prices rise the following year but remain below the previous peak, some annuities credit you with a gain, but others don’t. Stocks can rise while your annuity earns nothing (the reverse can happen with certain types of annuities). The upside, in bear markets, is that your annuity didn’t lose, which is the reason people buy it. I think you’re giving up more than you realize for this peace of mind.
What if you want to quit the annuity early?
Some insurers pay you only the guaranteed minimum return. Some credit you with all or part of your earnings to date but impose a surrender charge. You might lose money if you withdraw ahead of time. Some annuities let you take 10 percent of your money every year penalty free. Others will make the distribution but build a penalty into your ultimate return. You owe income taxes on the money you take out and a 10 percent penalty if you’re under 59 1/2.
What are the fees?
Hard to tell. There are annual fees, usually up to 2.5 percent, and early withdrawal fees. Ask the salesperson to write them all down for you. Fees are deducted before the insurance company credits you with interest. The sales materials may claim “no commission,” but of course, you pay one, buried in the fees. Commissions run from 5 to 10 percent and sometimes as high as 15 percent of the money you put in.
How are you taxed?
It’s all ordinary income, even though it’s linked to stocks. You don’t get the low rate on capital gains.
What if the investment shows a loss when it matures?
You receive the annuity’s minimum guarantee. It’s typically quoted as “1.5 percent,” but 1.5 percent of what? You assume that it’s 1.5 percent of the money you put in, but it’s often not. It could be 1.5 percent of 90 percent of your investment. For 5- to 10-year holding periods, that works out to a guarantee of 0.43 to 1 percent a year. Assuming 3 percent inflation, you have a loss—not in the nominal capital but purchasing power. (If an annuity guarantees 6 percent, which sounds terrific, it might be 6 percent on only 30 percent of your investment—but you have to probe to find out.)
There’s one risk here that I don’t know how to evaluate. Insurers usually hedge their obligations to pay with a variety of financial instruments. In essential markets (think 2008), these instruments can behave in unusual ways. Any unexpected losses will adhere to the insurer, not you. But the insurer may recoup by reducing the percentage of stock market growth with which it credits your contract. So be very clear about your minimum guarantee.
An Alternative to an Equity-Indexed Annuity:
Divide your money between a fixed annuity and a stock-owning mutual fund in a way that guarantees that you’ll get your total investment back plus a chance of capital gain. Here’s an example of that strategy, with thanks to Peter Katt, a fee-only life insurance adviser:
Assume that you start with $100,000 to invest. Put $64,333 into a 10-year fixed annuity earning 4.5 percent. At the end of the term, you’ll have your $100,000 back. Put the other $35,667 into a well-diversified stock-owning mutual fund. Over the term, the odds are that your stock fund will rise in value— so you’ll lose nothing and will have a gain that’s taxed at the low capital gains rate. If your stocks fall in value, you still have $100,000 and can hold the stocks for an even longer term, waiting for recovery.
A Word About the Brokers, Agents, and Financial Planners Who Sell Equity-Indexed Annuities:
Some of them know how flaky this investment is and don’t care. Others don’t know—they simply trust what the insurance company told them. When they find out what happens to some of their customers, they’re shocked and quit selling the product. I do blame salespeople for not understanding what they sell, but the ultimate responsibility for this toxic waste lies with the insurance companies and securities firms—a cynical crowd.
Laura Bushnell is Editor in Chief for National Review Brand Foundation of Consumer Updates and based in Boston. Previously, she held senior VP level positions in corporate finance and consumer financial planning firms.