Pros and Cons of Equity-Indexed Annuities
In my experience, the only people who think equity-indexed annuities are a good idea are those who sell them, usually to unsophisticated seniors after a free steak dinner. Imagine my surprise to read, in an otherwise very good book, an opinion to the contrary.
Hank Parrott, ChFC, AEP, RFC, has a small section in his 7 Steps to Financial Freedom in Retirement about equity-indexed annuities. He had bad things to say about variable annuities (as expected) and good things to say about fixed annuities (again, as expected) and then launched into his section on equity-indexed annuities (which he also refers to as “fixed index annuities.”)
[These] are fixed annuities that have potential earnings linked to a stock or bond index such as the S&P 500…It is important to understand that you do not actually own the stocks, but that the returns are tied to the performance of the index. These unique investments offer the principal guarantees and built-in minimum rates of return of fixed annuities, while also providing the potential for higher returns based on a percentage of the gains in the index to which they are linked. You are thus able to reap some of the benefits of gains in the stock market, while protecting your principal against the risks of a catastrophic drop like we saw in 2008.
Most of these annuities limit the amount of gains you receive through provisions such as a participation rate. So if your participation rate is 50 percent, and the S&P 500 is up 22 percent, your account would increase by 11 percent…While the potential gains may be less than you would get from investing directly in an index mutual fund, many of the clients I work with like the idea of protecting their principal and don’t mind giving up some potential return for that protection. Indeed, there are times, usually in a bear or sideways market–that a fixed index annuity may outperform the market index to which they’re linked. This is due to the fact that you are participating in the gains of the market without having to make up for the losses. Fixed index annuities have historically offered a rate of return in the 3 to 7 percent range over time, though it’s important to meet with a trusted financial adviser who can help you find an annuity that offers the best rate and other features to best obtain your objectives…
Later, he discusses charges:
Oftentimes clients come into my office and ask about the charges associated with annuities. They mention how they’ve heard about annuities but their source…warned them about the costs associated with these products. It is important to know that charges and fees are only relevant to variable annuities. This is due to the fact that you are charged a fee no matter the performance of the index the annuity is linked to…rather than get caught up in trying to figure out what insurance companies’ fees and expenses are relative to those attached to CDs by banks, you should instead consider what overall features and benefits within the respective products work best for you…The important point to understand here is that you are not expected to be able to understand, manage, and purchase annuity products on your own.
For the counterpoints, we’ll take a look at Larry Swedroe’s excellent The Only Guide to Alternative Investments You’ll Ever Need, a book which divides alternative investments into The Good, The Flawed, The Bad, and the Ugly (which only has two categories, one of which is equity-indexed annuities):
An equity indexed annuity (EIA) is another one of those products described by the people selling them as providing “the best of both worlds”–the potential rewards of equity investing without the downside risks (because of the guaranteed minimum return.) The typical EIA offering has the following characteristics:
- A link to a portion of the positive changes in an index [which portion varies] between 50 and 100 percent
- Principal Protection
- A minimum rate-of-return guarantee, regardless of the performance of the index
- Tax-deferred growth potential
- Income options to meet investor’s specific needs
- A death benefit guaranteeing beneficiaries 100 percent of the annuity’s indexed value
Investors seem to find these characteristics irresistible, purchasing an estimated $25.1 billion worth of EIAs in 2007….tripling since 20001. Another explanation for the explosion in sales is that commissions on EIAs average 8.5 percent…hidden in the form of high internal expenses and surrender charges.
The typical EIA provides far less than 100% of the index’s return…First…most EIAs have participation rates….between 70 and 90 percent, [second is] through the use of an annual cap–the maximum rate at which the annuity can be credited. For example, the S&P 500 rose almost 29 percent in 2003 [but] an EIA might have limited the gain to…perhaps 12 percent, less…expenses. [Third, dividends don’t count toward payout, only the price change of the index. Fourth is] the use of a margin fee…For example, in the case of an annuity with a [margin fee] of 3 percent, if the S&P 500 gained 9 percent, the return credited to the annuity would be 6 percent. Fifth…[they use] simple interest instead of compound interest.
Swedroe also discusses several ways in which the “change in the index” can be calculated. Not surprisingly, all of the various ways benefit the insurance company at the expense of the investor. He also points out that the “minimum guaranteed return” isn’t necessarily based on 100% of the value of the annuity, but often only 90%. He discusses early surrender charges, sometimes as high as 22%, as well as explaining how EIAs essentially convert what would tax-efficient capital gains into tax-inefficient regular income.
While there may not be a perfect correlation, the following is a good rule of thumb to remember about all financial products: The larger the commission, the worse the investment. The reason is that the worse the investment, the higher the commission that must be offered to entice the salesperson to devote time and energy to selling the product. The bottom line is that large commissions explain both why the products are heavily sold, and why these products are meant to be sold, but never bought…In 2006, Dengpan Luo and Craig McCann coauthored a paper on EIAs. They found that an astounding 15 to 20 percent of the premium paid by investors purchasing EIAs represented a transfer of wealth from unsophisticated investors to insurance companies and their sales forces. They concluded, “Insurance companies add trivial insurance benefits, disadvantageous tax treatment, and exorbitant costs to mutual funds and sell them as equity-indexed annuities.” Our conclusion is that EIAs are the “poster children” for products that are too good to be true….An EIA represents a good reason why investors should avoid products that are inherently complex.
I find Swedroe’s arguments compelling. In my experience, complexity always favors the issuer of a financial product. I’m disappointed to see Mr. Parrott arguing for these flawed products (or at least not outright proclaiming their wickedness). An EIA is a great idea, but the execution is flawed and the devil is in the details. All it takes to see through these things is a bit of common sense. How can an insurance company give you most of the upside of investing in stocks without any of the downside? They don’t have a magic box for their investments. They have to invest just like anybody else PLUS they need to make a profit PLUS they have to pay these huge commissions to their sales forces. The bottom line is that the money for the profits and the commissions comes out of your pocket, and what you get in return is of far less value. The guarantees that seem so attractive to the purchaser, while valuable, are simply sold at far too high a price. Avoid complex financial products and don’t take investment advice from commissioned salespeople.