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Indexed Annuities: Too Good to be True?
Penalties, caps and fees drive down income on equity-indexed annuities.
September 2006
By Lynn O'Shaughnessy
Perhaps you have heard about a miracle investment that allows you to enjoy the gains of the stock market without losing any principal. If you haven't gotten a pitch yet for an equity-indexed annuity, you probably will. Last year, consumers sunk a record $27.3 billion into these products, according to Advantage Compendium, a St. Louis-based research firm that tracks the industry. And more than 30 companies are churning out new products to capture the lucrative baby-boomer market.
But before you plunk down your savings on an equity-indexed annuity, you better understand how this complex product works. Its confusing features and big fees, as well as agents' aggressive sales tactics, have attracted the attention of government regulators and class-action litigators. "You should stay away from most equity-indexed annuities," says Chuck Newton, a financial adviser at Brecek & Young Advisors, in Salt Lake City. "There are more than 500 of them, but only about five are any good, if that many."
An equity-indexed annuity is a type of deferred fixed annuity, which provides investors with a guaranteed minimum return while allowing them to save for retirement on a tax-deferred basis. What distinguishes the equity-indexed annuity from the traditional annuity is that its returns are partially linked to stock market indexes, usually the Standard & Poor's 500-stock index.
But investors who believe that these annuities will match stock market returns in a bull market will be sorely disappointed. The index-linked return is based on a formula described in the insurance contract. The "participation rate" determines what percentage of the gain in the stock market index will be credited to your annuity. For example, if the participation rate is 80% and the index increases by 8%, the interest credited to your annuity will be 6.4%.
Other calculations will also gnaw at your return. For instance, most annuities exclude the value of dividends from the gains in the index. And some impose a monthly or yearly cap on your return, no matter how well the market does. What's more, insurers can charge an asset fee, which ranges from 2% to 2.5%.
"There are probably 100 different ways to credit interest, and you literally need a degree in industry methodology to understand," says Scott Dauenhauer, a certified financial planner at Meridian Wealth Management, in Murrieta, Cal.
Guaranteed Returns on the Low Side
One attraction of equity-indexed annuities is that when Wall Street is performing poorly, investors are promised a guaranteed minimum return--typically a 3% annual interest rate. But the guarantee may be based only on 80% to 90% of your original investment. If your guarantee is based on 80% of your money with a contract that lasts 12 years, the effective annual return would be a paltry 1.1%, according to Jeffrey Voudrie, a certified financial planner with Legacy Planning Group, in Johnson City, Tenn. Any gains are taxed as regular income rather than at the lower rate for capital gains.
Unlike stock-index mutual funds, equity-indexed annuities are long-term contracts with substantial penalties for early withdrawal. In many cases, the investors must tie up money for a decade unless they pay surrender charges of 10% or more. Ronald Marron, a lawyer in San Diego who has filed class-action lawsuits against two sellers of equity-indexed annuities, says one of his elderly clients, who sunk $1.5 million into an equity-indexed annuity, would have had to pay $263,000 to escape the contract. Typically, insurers do allow customers to withdraw 10% a year without penalty.
The industry says the products are a godsend for investors who are terrified of stock market drops. "What happened from 2000 to 2002, with the three years of losses in most of the major market indexes, made a lot of people aware that they needed a higher percentage of their money in safe, secure instruments," says Mike Tripses, chairman of the National Association for Fixed Annuities. Older investors can't always wait out a bear market, he notes.
But Craig McCann, former Securities and Exchange Commission economist and president of Securities Litigation and Consulting Group, in Fairfax, Va., says investors can do as well or better with a simple portfolio of Treasuries and a diversified stock mutual fund. His analysis is available at www.slcg.com. Also check www.guardingyourwealth.com, a Web site run by Voudrie, the financial planner with Legacy Planning Group.
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