Beware of Equity Indexed Annuities

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If it looks like a duck and quacks like a duck, it's a duck, right?

Not always, when it comes to annuities.

Equity indexed annuities may be among the annuity options available in your 403(b) or 457 plan. But they are quite different from fixed annuities and variable annuities, the more commonly offered annuity options.

Let's Compare Annuities

With a fixed annuity, you receive a minimum rate that is guaranteed by the issuing insurance company.* Fixed annuities are generally considered conservative investments because the insurance company guarantees your principal (the amount you contribute) as well as your return. In exchange, you accept what is generally a low rate of return. Fixed annuity vendors and sales representatives are regulated by state insurance agencies.

With a variable annuity, there is no principal or return guarantee during the accumulation phase (the period of time you are contributing to the annuity). Instead, your return depends on the performance of the underlying investments that make up the subaccounts you choose from among those offered by the insurance company. When the investments that make up the subaccounts do well, you do well. Conversely, if the funds in the subaccounts lose money, you lose money. In return for the risk you take, you have the potential to make more money than you could on a fixed annuity.

Variable annuity vendors and sales representatives are regulated by the state insurance agency, Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA).

On the surface, equity indexed annuities may appear to offer the best of both worlds – a guaranteed minimum rate as well as the opportunity to earn a higher rate of return based on the performance of an underlying index.** In fact, that's probably how the sales rep will position them. But it's important to look closer.

Equity indexed annuities are contracts between you and an insurance company. They are complex financial instruments that often have complicated ways of calculating your rate as well as excessive fees. Although the rate paid by the equity indexed annuity is tied to the performance of an index such as the S&P 500, that does not mean you will receive the full benefit of the returns posted by the index. Here's why:

  • Many equity indexed annuities put a cap on the interest rate they will pay, regardless of the performance of the index they are tied to. So if, for example, the cap is 6% but the underlying index earns 10%, the rate paid is only 6%.
  • Some equity indexed annuities include a "participation rate." This is a percentage of the return of an index that they will pay. For example, if the index the insurer is using earns 10% and the participation rate in the contract is 50%, the return the equity indexed annuity will be credited is 5% (10% index return x 50% = 5%).
  • Some use a spread or margin fee instead of a participation rate. If the spread is 3.5% and the index gains 10%, you would be credited with just 6.5% (10% - 3.5%).
  • Others use different indexing methods, such as comparing high and low points from the beginning of the year to the end of the year, from the beginning of the contract to the end of the contract or during contract anniversary dates.

Although equity indexed annuity returns are tied to a market index, in most cases they are not considered securities. Therefore, they are not regulated by the SEC or FINRA, and the people who sell them are licensed insurance agents who do not need to have a securities license. An attempt to have them regulated by the SEC was vacated by the courts in 2010.***

In addition, like most fixed and variable annuities, equity indexed annuities generally have surrender fees, and they are often higher and last longer than other types of annuities. If you decide to get out of the equity indexed annuity before the surrender period, you will likely lose money. For example, if the equity indexed annuity surrender fee starts at 10% in the first year and steps down 1% a year over 10 years, you would have to pay an 8% surrender fee if you decided to cancel it in the third year. Equity indexed annuities may also have administrative fees.

Finally, be sure you understand how the guaranteed rate applies. Some equity indexed annuities pay a guaranteed rate on only a portion of the principal. In addition, the guaranteed rate may apply for only a certain period.

Look Before You Leap

If a sales rep tries to convince you to buy an equity indexed annuity, be sure to ask the right questions:

  • Is this investment really suitable for me?
  • You're telling me I can get stock-market-like returns with no risk. That's not true. Can you tell me what the index being used is and how you calculate the rate paid by the equity indexed annuity?
  • What are the fees involved with this product? What is the surrender fee schedule and how long does it last? Does the surrender fee schedule start with the beginning of the contract or does it roll over again with each contribution or every year?
  • May I have all the information about this product, including how the return is calculated, fees and expenses, in writing?

And consider this. Equity indexed annuities can be so complicated that FINRA has an online alert to make sure investors understand what they are buying.

* Annuity guarantees are subject to the financial strength and stability of the issuing insurance company.

** Many equity indexed annuities are tied to the S&P 500, although they may be tied to other indexes. It is important to remember that past performance is not an indication of future results, and that individual investors cannot invest in an index.

Source: The Wall Street Journal, July 19, 2010,