Equity-indexed Annuities (EIA’s) are complex investments sold by insurance companies that pay investors part of the capital appreciation in a stock index and guarantee a minimum return if the contract is held to maturity. These products have soared in use and popularity in recent years and are common features of offers with “Free Steak Dinners” and “Informational, Retirement Planning Seminars” that you will get via post cards that you will receive (if you haven’t already) as soon as word gets out that you are over 50 and have more than $10,000 to invest.
The number of people who hate the products is too long to list. One recent publication from the Securities Litigation and Consulting Group states, “Insurance companies add trivial insurance benefits, disadvantaged tax treatment, and exorbitant costs to equity-participation securities and sell them as equity-indexed annuities.” They go on to write that,
“repackaging equity-participation securities as equity-indexed annuities has heretofore exempted them from effective securities regulation. One consequence of this is that in these cases investors in unregistered equity-indexed annuities cannot trace back through returns in the markets to the returns their investments will earn. Also, as a result of the lack of SEC and NASD oversight, investors in equity-indexed annuities cannot determine the costs they are incurring. Moreover, equity-indexed annuities’ complexity makes it virtually impossible even for brokers and agents to properly evaluate the annuities. Salesmen can readily determine though that commissions paid for selling equity-indexed annuities – as high as 10% or 12% – are much larger than commissions paid on mutual funds and variable annuities.”
I think it’s fair to say that the writer is not a fan of these instruments.
To be fair, I think that this is unnecessarily harsh. More recent information from the SEC sheds a bit more light on the subject, but like many government documents it makes things both more and less clear. Part of the problem is the confusion between an Equity Indexed Annuity and a Fixed Index Annuity. A true Equity Indexed Annuity behaves like a security. The SEC regulates these items. The term “security” is key here in that it allows a loss of value to take place when the related index goes down. Most Fixed Index Annuities do not, thus they are exempt from SEC regulation and instead are treated as insurance contracts regulated by each state. This leads to all sorts of chaos because we may have 50 different sets of rules to work with depending on which state you live in.
These index annuity contracts produce returns that are a little complex in that multiple terms are involved in the calculation. However, this does not necessarily mean it is a bad deal. To understand whether this works for your situation, you have to look at the terms spelled out in each contract, but here are a few elements that you are likely to see and a few issues to think about as well.
If we think about the EIA as a contract, it will have some value at a future point in time and the annuity payments which follow will be placed on a schedule with payouts based upon this amount. The key question is how is this amount derived? It will begin with what you pay into the account. This can be done in a lump sum, or in installments. After those payments are made, the account value will continue to evolve based on what the underlying index does and the other terms of the contract. The key attraction is that if the “market” goes up, you get more money and if it goes down, you either don’t lose anything, or you lose a lot less than you would if you owned the index fund itself.
Let me get this straight. If the market goes up, I win, and if it goes down, I don’t lose anything – sign me up!!!! At least, that’s the response they are looking for. But let’s lay out a few more details before we jump in.
- Dividends are usually excluded from the discussion. This is a HUGE red flag for me. The contract typically ignores dividend payments from the index. The average dividend yield on an S&P 500 index fund over that past 40 years has been around 2%. Thus, if the annuity ignores this, it is comparing its return to a biased sample. If the S&P 500 index goes from 100 to 99, you lost 1% right? Well not really because you collected the dividends, so when the indexed annuity says you are better off with the annuity, that’s not a fair statement. You are really comparing the return on asset X with the return on asset Y minus 2%. This makes X look a lot better.
- Only a portion of the index performance is realized as your gain. There is often a Participation Rate which is the portion of the index gain that can come to you. If you have a 75% participation rate and the market goes up 12%, the most you will see is 75% * 12% = 9%.
- There is also likely to be a rate cap. This is the maximum you can get, regardless of how much the market goes up. For example, you may have a 7% rate cap. If this instance, instead of seeing 9%, you will only really see 7%. Note that if the market goes up 24%, as it did in 2023 you will still see only 7%.
- Look out for fees that are not called fees. You typically see a “spread” in these contracts as well. For example, a Spread of 3% would mean that if the index goes up 12%, the subsequent calculations are actually based on a figure of 12 – 3 = 9%. In this case, you see 75% * 9% = 6.75%. This will not be called a fee, but it sure acts like one. In fact, these are sometimes called “Administrative Fees.” However, most contracts drop this term, because buyers don’t like the sound of it.
- Indexed Annuities typically offer a Floor. This is the real selling point. For example, if the floor is -10%, then the most you can lose in a year is 10% (sort of). This is key. The index dropped in 2022 by 18%, but with this type of annuity, you would only lose 10%. Many of these contracts simply set the floor to 0, meaning you cannot have a loss in value due to the market decline. (Of course, you can still lose if there is a fee.) If the floor is set to 0, you can claim that this is not a security – and avoid SEC regulation.
- However, there can also be a Buffer, or Shield. For example, if the Buffer is 12%, then the insurance company will reduce your contract value by the difference. For example, if the Floor is 10% and the Buffer is 12% and the market drops by 18% you actually lose 18% – 12% = 6%. That’s better than losing 18%, but its still a loss.
While all of this may sound complex, rest assured, its actually more complex than that. I have not touched on how much of the original funds you put into the instrument actually gets there. The agent selling the item does get a commission up front. However, in some cases, the contract is written to indicate that no commission is actually paid. The insurance company shares some of the “benefits” with the agent later. This makes it look like you paid no fee – but the money had to come from someplace, and if it goes to the agent, it didn’t go to you. There are also sliding penalties if you take the money out too soon, and riders that you can add (for additional fees) for things like inflation protection, long term care, and enhanced survivor benefits. Again, read the contract and decide accordingly.
My main complaint is a simple one. Ignoring the dividend is a HUGE deal. It doesn’t sound like much – hey what’s 1 or 2% between friends. But consider this. If I invest $100 in 1974 in the S&P 500 and got no dividends to reinvest I would have $1,768 by 2004. Not bad. However, if I got the dividends and reinvested them, I would have $4,921. This is 2.7 times as much. Dividends matter.
However, here is where it gets a bit creepy. Many of these contracts use something called – the monthly average return method. This calculates the increase in the index level from the start of each year to the average month-end level during the year. The base is then reset at the start of the next year and the process goes on. Huh? (That’s what I said.) It works like this. Let’s say the index from January to December goes up from 101, to 102, to 103, etc. up to 112 at Dec 31. The calculation is based on the average of these values which works out to be about 106, not 112. Using this method, with the same data used above you would end up with $544. Thus, the S&P 500 with reinvested dividends pays almost 8 times as much.
I can go on, but let’s deal with the 800 pound gorilla in the room. Is the insurance company making the product more complex for your benefit, or theirs? Let’s keep this simple. If you want MY money, and you offer me a contract that only YOU understand, should I assume you wrote it that way to help me? My answer is “Not just no – but HELL no!”
