Bob Clark, a columnist for Investment Advisor magazine, recently said, "...the role of advisors is to protect their clients from the financial services industry". Many times the products pushed by the large financial service firms do more harm to investors than good. The "hot" product du jour is currently the Equity Index Annuity.
While the equity index Annuity itself is not an evil thing, the way they are presented to investors is many times misleading, and they are often pushed to be a much larger part of a portfolio than prudence would justify.
In brief, an equity index annuity, provides returns that a related to some stock market index. As such they can be viewed as an equity derivative (remember those?). Investors typically receive a return that is some portion of the return of an index like the S&P 500 (for example 90% of the point to point return of the price increase of the index, not including dividends), the average monthly return of the index over a predetermined period (again not including dividends), or the monthly gain of the index with a predetermined cap (often 2-3% per month cap). The big draw is that you receive a guarantee that your account will not have a negative return over some period of time. Often touted as "heads you win, tails you don't loose". On the face that sounds enticing. It is only if you kick the tires that problems become apparent.
First, like most annuities there is a long period of time where you a charged a surrender charge if you want or need to withdraw more funds than allowed in the contract (I have even seen instances where the surrender charge is applied to any withdrawal except in the case of annuitization).
Second, any gain from annuities is considered to be distributed first, and taxed as ordinary income (you do not get favorable dividend of capital gain rate when you file your taxes), and any distribution before age 59 1/2 could be subject to a 10% premature distribution tax penalty.
Worst of all the returns investors receive will likely not measure up to expectations. The pitfalls of monthly caps and averaging returns requires some contemplation to understand. Let's say you are credited with any market gains up to 2% each month. That means if the index you participate in goes up by 2% you are credited with the full 2%, if the index goes up 3%, sorry, you are still only credited with 2%. Okay, you say, that's not so bad, I can still earn a whopping 24% in a year! In theory yes, in practice, no. See sometimes, even in a very good year, markets will fall back some months. And you equity indexed annuity lets you participate fully in the monthly market drops, as long as the account moves no further than 0% in a year. If the index you participate in rises by 3% one month, the 1% the next month, but falls by 3% the following month, your account earns zero, nada, zilch. You were credited with 2% the first month, then 1% the second month, but got dinged for the full minus 3% in the third month.
It's all very confusing, and people hear what they want to hear. That is what the insurance companies and agents who sell equity index annuities are counting on. Heads the insurance company wins, tails, you lose.
We all have a tendency to hear what we want to hear. It seems to be especially true of financial products and services.
I am often asked about the guarantees that variable annuities and equity index annuities offer. For example, this week I spoke with an individual who owned an annuity that offered an annual 7% step up in calculating the lifetime income benefit rider. The client thought that meant they earned at least 7% per year on the money they had invested in the variable annuity. Here is how the guarantee actually works:
Every year the insurance company looks at the value of the annuity contract and if the value of the underlying investments (after the insurance company had extracted about 3.4% in fees) was less than 7% higher than the previous anniversary date, the account was credited with a 7% increase for the purpose of calculating the 4% annual guaranteed lifetime income benefit. That is not 7% that the client can withdraw, but an increase in the calculated annual income benefit.
Still not clear?
Investment in a Variable Annuity: $100,000
Initial Guaranteed Lifetime Benefit: 4%
Annual Income for Life: $4,000
Here the insurance company is only guaranteeing that should you earn net zero on the account and withdraw and spend your principal for 25 years, they will step in and send you $4,000 for however long you live. If you live 30 years, then the insurance company is on the hook for $4,000 for the 5 years after your account was depleted. The cost of this rider is 1.1% per year.
If the underlying investments in this account earn 3% by the first anniversary date, the client can withdraw $103,000 less any contingent deferred sales charges, but the account is credited as if it had earned 7% for purposes of calculating the guaranteed lifetime income benefit.
Income Benefit Base: $107,000
Annual Income for Life: $4,280
Now the insurance company is promising to return your principal for 23.36 years and step into the breach if you live longer to the tune of $4,280 per year. So the longer you wait to receive income the bigger your guaranteed check, but also the less life expectancy you have to draw the check and the longer the insurance company gets to pick 3.4% per year from your pocket.
Still not clear? You are not alone. Seek help from an advisor who doesn’t get paid to sell you a product!
Photo:By Ion Chibzii from Chisinau. , Moldova. - "Problems, problems..." (70-ies)., CC BY-SA 2.0, https://commons.wikimedia.org/w/index.php?curid=32730682
Variable annuities are often confusing and hard to understand. In addition to the fees charged for managing the sub- accounts (read mutual funds) within the policy consumers also pay for the insurance portion of the policy (mortality expense) and various riders and options offered with the policy. If you want to compare the expenses of owning or buying a variable annuity here is a simple grid that you can take to your insurance agent ( yes your broker is an insurance agent if she is offering you an annuity) for help comparing.
E-Z annuity fee disclosure checklist
Before you buy any annuity, ask your advisor to fill in the blanks.
What you pay each year
Annual fee (as % of account value) for: Number Typical
The insurance (a.k.a. mortality and expenses) _____% 1.35%
The investments within the annuity _____% 0.95%
Riders and options _____% 0.65%
Total annual fee: _____% 2.95%
What you pay to get out
Max. surrender charge (as % of withdrawal) _____% 7.00%
Number of years before surrender charge expires _____ 8
Source:Morningstar, National Association of Variable Annuities, Money research
Note: Max. surrender charge may not apply to all withdrawals.