As my list of questions expanded,
her responses contracted. She knew very little how her
hard earned retirement was invested. As it turns out,
my 30-year-old friend had placed her money into a rather
complex savings vehicle — an annuity. Even more,
this one had a fancy title — an Equity Indexed Annuity
(EIA). I began to wonder if my friend, who is rather ordinary
in her understanding of savings and investment choices,
was involved in an EIA, how many other people really know
what they are getting into?
Annuities Basics
Before we tackle the complexity
of an EIA, you should understand an annuity is
a contract sold by an insurance company. In exchange for
your lump sum “investment,” the company agrees to pay
you income for a certain length of time or for your life.
These contracts generally carry fixed or variable terms
and feature a tax-deferred component; meaning you can
wait to pay Uncle Sam on the income you receive.
Annuities offer the assurance
of a regular stream of income, tax deferred status and
the protection against losing principal with a poor investment
choice. This “guarantee” is important, particularly to
retirees who naturally choose low risk approaches to preserving
their retirement. The fear of losing everything is a valid
concern for many people and a real factor when entering
into investment decisions.
While annuities have a place
for certain people, they carry certain observable drawbacks.
The advertised tax-deferred growth is taxed at ordinary
income rates (for most people this is higher than capital
gains rates). Further, annuities are complex and often
restrict investment choices, lack liquidity, and offer
mediocre insurance coverage. Finally, it is no secret
that annuities are big moneymakers for brokers. No one
is against advisers making a living, but the high costs
call into question the efficiency of the savings. Remember,
everyone in the sales chain has to make some money in
order to offer it to you.
Equity
Index Annuity Basics
The equity indexed annuity
is a glorified fixed annuity. Like a certificate of deposit
(CD), a fixed annuity offers a modest return. The difference
with the EIA is in how it credits interest to your account.
Rather than paying the rate dictated by the contract,
the EIA pays a return using a complicated formula based
on a stock market index, like the S&P 500 Index. Investors
gain as the market index goes up, but are protected when
the market swoons by a minimum guarantee, usually 2% to
3% as stated in the contract. How is this possible? Insurance
companies use a variety of sophisticated investments,
including combining stock options and bonds to deliver
on their promise, lock in profits and protect themselves
from risk.
Looking Under the Hood
of the Vehicle
Upside with no downside —
sounds pretty good, right? Here is the main concern: When
adding the costs of deploying these sophisticated investment
techniques and the costs of paying the sales force, the
potential returns you can make are substantially reduced.
To better understand this problem; let’s take a closer
look at the way these are sold to individuals, the fees,
terms and complexity of the product.
Marketing
When you get asked something
like, “How would like you to make stock market returns
without the risk?” you know someone is selling an EIA.
With 7% to 15% commissions going to brokers, it is no
wonder EIAs have become a multi-billion dollar business
in the past few years. Consequently, the suitability of
an EIA for many investors is largely ignored.
Guaranteed stock funds
do not exist. Let’s call a spade a spade. This is
not a mutual fund or even a regulated investment
(like stocks, bonds or mutual funds); it is a savings
vehicle designed to give a better return than CDs
and money markets.
No matter who tries to sell
you an EIA, read the contract or get someone
to help you. The insurance company will follow the agreement
regardless of what a broker makes you believe it
says.
Terms
So what’s in the contract?
If you have the patience to read it (most people don’t)
you will find the following:
- participation rates (what
portion of the upside you really get)
- interest rate caps (maximum
upside you can get)
- surrender charges (ouch
— what you pay for pulling out early)
- withdrawal rates (how
much you can pull out each year without penalty)
- guaranteed minimums (promised
minimum return)
- indexing method (annual
resets, point to point, or high water mark)
- interest calculation (annual
averaging or compounding)
No two EIAs are alike, so
the terms and conditions are too numerous to explore here.
With mind-numbing detail in each contract, it is a big
question mark whether salespeople peddling these things
really know how they work.
If your eyes haven’t glazed
over by now, let’s pause to distill these terms into salient
points with a simplified example. Let’s say you lock $10,000
away in a 10-year EIA, with a participation rate of 70%,
interest rate cap of 12%, guaranteed minimum of 3% on
90% of principal and see what happens in three scenarios.
Scenario A: S&P
500 up 20%. You earn $1,200 (limited by interest cap)
compared to $2,000 earned in an S&P 500 index fund.
Scenario B:
S&P 500 up 10%. You earn $700 (constrained
by 70% participation rate) versus index of $1,000.
Scenario C:
S&P 500 down 10%. You earn $170 (90% of principal
earns 3%, or $270; 10% not protected tags you for $100)
compared to losing $1,000 in the market.
Clearly,
Scenario C is the saving grace. But look closely, only
90% of your money is protected — not exactly a
“can’t lose” investment. Some may argue the loss is minimal
and you bear no market risk while still getting the upside
of the market. Sure, but don’t forget that in no
scenario do you get all of the upside of the market.
Oh, by the way, while the
EIA return is tied to the S&P 500, this does not include
dividends. Historically, the S&P has returned just
over 10% annually, with about 4% coming from dividends.
If your investment goals
change, the surrender charge for cashing out before 10
years will cost you dearly in the early years, including
a hit of 5% to 15% and immediate taxation at ordinary
income tax rates on interest earned — although many EIA
contracts allow penalty-free 10% annual withdrawals. Some
advisers argue that long surrender charges are a blessing
in order to prevent you from missing out on the long-term
performance of the stock market. Seems like an expensive
way to maintain an investment discipline.
Investment Objectives
and Risks
It is clear that investors
in EIAs are trying to achieve two investment objectives
— preservation of capital and growth of their money. This
may be one of the keys to EIA popularity. What people
have done, however, is confuse objectives with risks.
Understanding the risk and potential rewards of both preservation
of capital and growth of capital would lead a reasonable
investor to allocate a portion of funds for each objective,
with lower cost and more flexibility.
For the stable portion of
your money, an allocation of CDs, U.S. Treasury Inflation
Indexed Securities (TIPS), government and corporate bonds
or REITs are better alternatives. Rates of returns on
these investments exceed the 3% of EIAs, while allowing
you more flexibility. Plus, as interest rates rise, these
alternatives are increasingly attractive.
For growth, an allocation
of low cost stock index funds (large, small, international)
can help you fully participate in market upside. In fact,
a 60% allocation of 10-year government bonds and 40% allocation
of an S&P index fund both held for 10 years, in each
rolling 10-year period since 1950, would have returned
no less than 3% per year! Even more, almost half the time
you would have earned in excess of 10% per year. These
are solid returns while retaining full access to your
money and avoiding high surrender penalties.
You Can Do Better Than
an EIA
My friend is no different
from the average retiree or investor. She hears about
the stock market upside with no downside. Artfully, the
EIA seems like a no-brainer investment. What is actually
happening, however, is a wealth transfer of premiums paid
by unsophisticated investors to insurance companies and
their sales forces.
EIAs are designed to exceed
the fixed income returns of CDs and money markets by 1
or 2%. This is not a stock market investment, but
instead a savings alternative. While ruling out
an EIA in every case would be unwise, the glaring costs,
limits on upside market returns, onerous penalties and
extreme complexity add up to an expensive way to investment
peace of mind. Unless you are inclined to pay, or a family
member gives you an EIA with no fees, other investment
options make sense for most people.
