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Indexed Annuities: The Big Lie

They know you want lots of money with no risk!

I started researching indexed annuities back in 2009 when my wife alerted me to an ad she heard on the radio. It was for an investment that claimed to offer incredibly high returns, around 12%, with no risk to your principal. She stated that it sounded a lot like an ad that Bernie Madoff might have run if he had used radio advertising.

I went online and found a similar ad from the same firm that alluded to returns as high as 25% stating,“our clients made between 10 and 25% two years ago and still have all those gains.” Dying to know what the catch might be, I visited their flashy website, (which has since become much more subdued it its approach).

The first thing that leaped off the page at me was the promise of a “10% cash bonus to transfer your accounts today!” They dangled the prospect of an immediate $50,000 in cash when you transfer $500,000. Who could pass up a deal like that?

I imagine that many prospective clients of Mr. Madoff or Allen Stanford’s firms were saying much the same thing. What a deal! High returns. No Risk. And a cash bonus to boot. Sounds good. Too good! Maybe even too good to be true? I am not implying that these people were involved in anything illegal.

This company was selling products known as equity-indexed annuities (EIAs). To make them sound even safer, some have taken to calling them fixed indexed annuities. These are relatively new insurance products (SunLife sold the first one in 1995) are still selling like hot cakes. In 2007, $25 billion was placed in indexed annuities. By 2015, sales had soared to more than $54 billion. With a “no risk, high return” sales pitch, I can see why!

This means that those who sold these products earned about $6 billion in commissions, based on the industry’s average commission of 10.4% of the amount invested. This should help you understand how those selling the products can afford to offer “free” steak dinners to lure you into their aggressive sales pitches. Each $100,000 indexed annuity sale is worth $10,000 to the salesperson.

Equity-indexed annuities are another insurance industry attempt to convince investors that they can have what they desperately crave, wealth without risk. Why invest in volatile mutual funds when you can get the returns of stocks with no downside? Those of us who have built diversified portfolios of no-load mutual funds must look pretty stupid.

I lost about 40% on my equity funds in 2008 (which only make up a portion of my total portfolio) while these brilliant equity-indexed annuity clients supposedly made 25% per year in 2006 and 2007 and lost nothing during the decline? What was I thinking? Was I missing something?

What’s missing is the whole truth, because current regulations require almost no disclosure of the realities of these hybrid products. That is why the SEC has tried and failed – thanks to the efforts of the powerful insurance lobby – to regulate indexed annuities as investments. In a letter supporting the SEC’s failed efforts a few years ago, the Securities Litigation & Consulting Group said that regulation “is needed because issuers of existing equity-indexed annuities obfuscate the investment risks to which investors are exposed by repackaging what is actually a simple underlying investment with a layer of virtually worthless bells and whistles.”

The truth is that equity-indexed annuities do not offer the return of the equities market.While each offering is different, equity-indexed annuities provide a fraction of the market’s upside.Typically, they offer only a percentage (the ”participation rate”) of the particular market index return and none of the dividends up to a maximum amount (the “cap”).

Also, most equity-indexed annuities sport steep surrender charges (the highest I have seen is 12%). In some cases, the formula for calculating your piece of the action is so complicated it takes several pages to explain. These are misleadingly sold, incredibly complex investments that rarely deliver anything near the client’s expectations.

annual total returns for Vanguard Index 500 fund from Morningstar

annual total returns for Vanguard Index 500 fund from Morningstar

The chart above illustrates a typical participation rate is 75% with a 5% cap (higher caps mean lower participation rates) versus the average annual total return (including dividends) for the Vanguard Index 500 fund. Since we can’t look forward, we can only use the past. Let’sassume you purchased a $100,000 indexed annuity on January 1, 2006 (just before the market took it’s worse one-year slide in history) with a 75% participation rate and a 5% cap based on the S&P 500 index. Take a look at your annual returns versus the Vanguard Index 500 fund:

annual total returns for Vanguard Index 500 fund from Morningstar

annual total returns for Vanguard Index 500 fund from Morningstar

From where do you think the magic money comes to pay you an upfront bonus, the agent a big commission and provide a nice profit for the company? That would be YOU! All of which must leave you with a smaller return!

There is no fiscal “free lunch.” These insurance firms and agents are not financial alchemists who have discovered a way to turn lead into gold. Although they have found yet another way to line their own pockets with gold, at your expense! 

Do only salespeople like them?

There seem to be a lot of well-respected publications that see equity-indexed annuities (EIAs) in a less than positive light (and that is an understatement). From what I can see, the only positive voices are those of the insurance industry or affiliated cronies. Considering the serious money to be made from selling EIAs is it any wonder?

In 2009, Barron’s Frederic G. Marks wrote an article on EIAs entitled,“Designed to Deceive.” Even before reading the piece I knew it was unlikely to be a ringing endorsement of the indexed annuity concept.

In this well-researched article, Mr. Marks discovered that, in one EIA example, the promised 3% guaranteed annual return ended up being 0.37% per year, for the first seven years. Over 14 years, it rose to a whopping 1.67%. Thanks to the miracle of complex qualifiers, embedded deep in the policy, they can magically reduce the claimed 3% by almost 50%. 

He calculated a real world, average annual return for the good market years of 2003-2006 (based on the insurance company’s own explanation of how gains are calculated - average monthly return) at 4.2%. He went on to look at what the gain would have been on this EIA over every rolling 10-year period since 1975 (there were 241 of them). Using the monthly average return method, an EIA would have returned 62% less than the S&P 500. 

Then, he offered a string of examples of the complex calculations used to baffle potential clients with BS (a standard method used to sell investments). All of them show just how misleading the “return of the stock market with none of the risk” pitch is. Mr. Marks concludes his piece with this important paragraph: 

“Equity-indexed annuities are insurance contracts so complex that it’s virtually impossible for customers or even brokers and agents to evaluate them. Yet salesmen can readily determine that their commission for selling an EIA will be much larger than commissions on mutual funds and even on other annuity products.” 

Money magazine called EIAs one of 3 retirement deals you can “do without.” Check out a Forbes article entitled, “Unwise at Any Age.” Kiplinger called them "An Annuity You Should Avoid." Even the securities regulatory body, FINRA has an Investor Alert about EIAs. There are hundreds more just like these online.

So, before you invest in an equity indexed annuity please carefully consider whether you believe the sales pitch of a person or organization that stands to profit from the sale. Or should you listen to almost every financial publication, respectable fee-only financial adviser (who are required to act in their clients best interest), and investment regulatory agency in the country? 

While I am unable to find a single redeeming feature of indexed annuities for those who purchase them (they are excellent for the salespeople), if you are considering placing some of your hard earned money in one, the National Association of Insurance Commissioners came up with these questions:

What is the guaranteed minimum interest rate?

What charges, if any, are deducted from my premium?

What charges, if any, are deducted from my contract value?

How long is the term?

What is the participation rate?

For how long is participation rate guaranteed?

Is there a minimum participation rate?

Does my contract have a cap? (How much?)

Is averaging used? How does it work?

How is interest compounded during a term?

Is there a margin, spread, or administrative fee in addition to or instead of participation rate?

Which indexing method is used in my contract?

What are the surrender charges or penalties if I want to end my contract early and take out all of my money?

Can I get a partial withdrawal without paying charges or losing interest? Does my contract have vesting?

Does my annuity waive withdrawal fees if in a nursing home or terminally ill?

What are the annuity income payment options?

What is the death benefit?

My guess is that asking these questions will leave the product peddler proposing this purchase puzzled and perplexed (please pardon my brief moment of alliteration - I couldn’t resist the opportunity). Any hesitation, dissembling, or obfuscation should provide a valuable clue about the veracity of their claims.

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