The lowdown on equity-indexed annuities
A tweet pitching equity-indexed annuities might read: "This insurance product enables you to participate in the upside of the stock market without exposing your nest egg to its downside."
But what seems both simple and sensible in 140 characters or less quickly becomes so complex and confusing in contract form that even financial advisers skilled in deep-woods investing tend to shy away from them.
What exactly are these purported no-lose investments? Who's most likely to benefit by acquiring them? And what are the brokers not telling you during the free introductory dinner they often use to pitch their product?
Anatomy of an annuity
An annuity is a contract between you and an insurance company, in which the insurer promises to make periodic payments to you, either starting immediately or at some future date, based on the money you invest.
Annuities once came in two flavors:
- Fixed annuity, which grows at a fixed interest rate similar to certificates of deposit.
- Variable annuity, a security instrument similar to a 401(k) account with an insurance wrapper, in which the money you put in is invested to mirror mutual funds, exposing it to both market earnings and risk.
The lowdown on equity-indexed annuities
In 1995, Keyport Life Insurance Co. introduced a hybrid of the fixed and variable forms of annuities, known variously as equity-indexed, fixed-index or simply indexed annuities. The hybrid annuity protects the principal invested while earning interest based on one or several stock market indexes, such as the Standard & Poor's 500.
Its timing couldn't have been better. Investors who purchased equity-indexed annuities, or EIAs, in the decade leading up to the 2007 financial collapse rode the runaway earnings without being tossed from the saddle by the market downturn.
By then, however, regulators and financial planners suspicious of this seemingly too-good-to-be-true investment option had begun to peek behind the curtain of annuities in general and EIAs in particular.
Are indexed annuities too good to be true?
The Financial Industry Regulatory Authority, or FINRA, the largest nongovernmental regulator for securities firms doing business in the U.S., issued an alert on EIAs in 2010. In it, the regulators dispel the tweet-pitch version of EIAs, noting that the products are "anything but easy to understand" and can lose money, despite sales pitches to the contrary.
"Complexity, cost and liquidity are the three biggest issues that investors need to be concerned about," says Gerri Walsh, FINRA's senior vice president for investor education. "Unlike some products where when you've seen one, you've seen them all, with equity-indexed annuities, when you've seen one, you've seen one. Placed side by side, it's hard to tell where there are similarities and differences between two different products. That makes it very difficult for any individual, whether consumers or sellers, to really appreciate the differences and the nuances of each product."
FINRA raises the following caution flags on equity-indexed annuities:
- Indexed interest rate: Insurers typically use a combination of indexing features, including participation rates, spread/margin/asset fees and interest rate caps, to compute return on the indexed portion of an EIA. To further complicate matters, many contracts allow the insurer to change these computing methods, either annually or at the start of the next contract term.
- Indexing methods: How and when an insurer credits the indexed interest to your annuity, and how that works in concert with the indexing features above, can have a significant impact on your EIA earnings.
- Exclusion of dividends: Some EIAs count gains only from market price changes and not dividends.
- EIAs can lose money: Insurers typically only owe you 87.5 percent of your paid premium with 1 percent to 3 percent interest. If you don't earn indexed interest, you could lose money.
- Liquidity risk: Because EIAs are long-term investments, withdrawing money early can result in surrender charges, usually a percentage of the withdrawal amount, or a reduction in the interest rate you receive. Any withdrawal from a tax-deferred annuity before age 59 1/2 is typically subject to a 10 percent tax penalty.
- Insurer risk: While rare, insurance companies have been known to fail. Before purchasing an annuity, check out the financial strength of the company offering it.
"Take the time to read the offering document," Walsh advises. "If you have questions that the seller can't answer, ask somebody who doesn't have a stake in the game, such as a trusted financial or legal or tax professional, to take a look at the prospectus for you and walk you through the pros and cons."
'It's a trust-me product'
Glenn Daily, a fee-only life insurance adviser based in New York City, offers an objective assessment. While he likes the concept of principal-protected indexed annuities, he can't recommend them in their current form to his clients.
"High commissions, high surrender charges, high taxes and a lack of transparency -- is that the best that we can do?" he wonders.
Daily says the sheer complexity of the product, the number of moving parts controlled exclusively by the insurer and the opacity of their commission and distribution costs make it impossible for financial advisers to determine whether an indexed annuity is worth the client's money.
"How do you create this product so it stands up to scrutiny? That's the problem: It's a 'trust-me' product," Daily says.
Not everyone sees EIAs as worthless
Lei Liang, a quantitative analyst at 40/86 Advisors in Carmel, Indiana, and Zhixin Wu, an associate professor at Indiana's DePauw University, co-authored a study published in the Journal of Financial Service Professionals in March that attempts to analyze the returns and risks of EIAs.
"It's not a good or bad product; it depends on your situation and time horizon," Wu says.
While a track record of barely 20 years isn't much to work with, Wu says the product's indexed exposure to the stock market tends to work for retirees and pre-retirees who won't need the money for years, and perhaps decades.
Stock investments can make sense for retirees, as well, if they limit their exposure and can withstand the inevitable slump. "If you can hold your position, given some time, it will improve. Decent long-term returns can be expected. But if you panic in a downturn and sell, you will lose," Liang says. "And if you're retired, it's harder to recover from that."
Investors in EIAs face little volatility, even in the bear market for stocks, because of guaranteed minimum return. Because they don't have to worry about losing principal, little panic-selling is expected.
Walsh admits that equity-indexed annuities, though far from perfect, may work for those willing to perform the necessary due diligence on a complex product.
"If you are an investor who will likely not need to access the money that you put into an equity-indexed annuity for quite a long time, have maxed out on the tax-advantaged retirement savings vehicles available to you, including 401(k)s and IRAs, and you understand the pros and cons of the product, then this might fit well within your portfolio," she says. "But those are three significant ifs."