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by Rick Willeford, MBA, CPA, CFP
"Doctor, are you tired of losing money in the market?" begins the opening pitch. "What if I told you I had an investment that would give you some of the upside potential of the stock market but guarantee that you could not lose money?" Does this sound too good to be true? Then read on.
The investment turns out to be an "equity indexed annuity," or EIA. The pitch sounds tempting, especially as the stock market goes through one of its periodic tumultuous periods. Perhaps it's too tempting. The National Association of Securities Dealers (NASD, which regulates broker-dealers) is so concerned that the product is being over-hyped and oversold that it issued an Investor Alert in June 2005. So, what's the rest of the story?
First, here's some background on annuities. In their simplest form, you used to give an insurance company a sum of money in exchange for their giving you a guaranteed monthly check for the rest of your life. The beauty was that you couldn't outlive your money. But part of the price you paid for that guarantee was that the returns were pretty stodgy.
Annuities have come a long way since that basic model. Nowadays many people start investing every year, like any other savings plan. Part of the allure is that the investments grow tax-free. (A more appropriate term is "tax deferred." You pay ordinary taxes when you withdraw the money later, like with a retirement plan.) Being a good red-blooded American (and smart dentist, to boot), you're probably not satisfied with your father's fixed-return annuity. So the insurance company will let you spice things up by letting you invest your annuity money in mutual funds, with the hope of a higher return. These are called variable annuities, vs. the more conservative fixed annuities.
As with variable life insurance products, both you and the insurance companies should be happier. You, because you hope to make more money with mutual funds, and the insurance company, because they are not obligated to promise you a specific return. That's your responsibility.
So where"s the rub? For one thing, the terms are so complicated that most salesmen, er, "financial planners," do not really understand the product. For another, the details are in the fine print, and we warn clients that there is rarely any good news in the fine print. Let me give you enough information to at least suspect some of the issues. I apologize in advance for some of the "techno-speak."
First, let's look at the guaranteed minimum return, which is typically around 3 percent, less than a U.S. Treasury security with the same maturity. You may ask, 3 percent of what? Believe it or not, it may be 3 percent of only a portion of the amount invested (such as the surrender value). Also, the 3 percent may not be compound interest, and the contract may require you to hold the product for 15 years to get credit for any interest! Or it may require you to actually "annuitize" the contract (e.g., convert into lifetime payments) rather than just withdraw your money. The problem is that 97 percent of all annuities never get annuitized. They get cashed in instead. Read the fine print!
Second, it takes a combination of a finance degree and a legal background to understand the "equity indexing" part, which lets you participate in some of the upside gains in the stock market. The annuity value is linked in various ways to the change in the level of a stock price index ("index change"), like the S&P 500 Index.
The first gotcha is the phrase "index change." When you think of the S&P Index growing at an average historical rate of around 10 percent per year, the "total return" includes dividends. The annuity excludes the impact of dividends because the annuity contract literally means just the "change" counts, and this immediately reduces the potential "return" by about 20 percent!
The annuity does not normally give you credit for 100 percent of the index change. Instead, the annuity specifies a "participation rate," normally between 50 to 90 percent of the change. After the gross change is multiplied by the participation rate, then the annuity may subtract a set "spread" that may be as much as 3 percent, then you get credited with the rest. So if the gross change is 10 percent for a year (vs. 12 percent if dividends had been included), the participation rate is 70 percent, and the spread is 3 percent, then you only get credit for 10 percent x 70 percent = 7 percent – 3 percent = 4 percent. That"s a far cry from the total return of 12 percent!
There is often a cap of 1 percent per month (12 percent per year) that limits the amount of change that can be counted. This has an insidious effect because the average long run return from stocks is heavily influenced by years with abnormally high returns. Not only does the annuity slash the effective return that is allowed, it also severely limits your upside potential returns in good years.
