What Are Equity Indexed Annuities?
Equity-indexed annuities (EIAs) are contracts between an investor and an
insurance company in which the investor's return is based on an equity
index, like the S&P 500. EIAs are typically sold as simple, easy-to-understand
investment products that carry virtually no risk. They are often positioned
to unsuspecting customers as offering market-like returns without any
exposure to market risk. In many cases, EIAs are hyped as promising a
guaranteed minimum annual return.
In reality, EIAs are some of the most complex investment vehicles on the market.
EIAs May Be Good for the Broker, But Not the Client
Investors love equity indexed annuities. At least, until they purchase
one. The promise of a "guaranteed minimum return" that is linked
to a stock market index without the risk of loss is just too good to pass
up. Unfortunately, many investors do not realize that this "promises"
is a sales pitch, not a reality, until it is too late. The truth is, EIAs
are rarely ever bought; they are sold.
The average commission for an EIA is in excess of 10%—nearly twice
as much as the commissions paid on fixed annuities. While financial advisers
are entitled to make a living off of a fair commission, the exorbitantly
high commissions associated with equity indexed annuities (or fixed indexed
annuities, as they are sometimes called) result in abusive sales tactics
that aggressively push an inherently complex product to investors—particularly seniors.
The Devil Is in the Details
The insurance companies that create the products spend millions of dollars
on glossy marketing materials that promote the upside potential but neglect
to adequately explain the surrender costs, asset fees, caps, commissions,
lack of dividends, and, most importantly, the sheer complexities of these
products. The reality denied by the marketing is that the costs of an
EIA (which are high), the limited upside (caps), and the complexities
of the product (of which there are many) make these policies some of the
most complicated investments sold today.
To understand how complicated these products can be, consider an EIA with
the common "guaranteed minimum return" of 87.5% of the premium
paid plus 1 to 3% interest. The EIA also comes with a participation rate
of 8%, fees of 3.5%, and no cap rate. These details all mean that if the
EIA is linked to an index that gains 1%, the EIA will only gain 4.5%.
If the insurance company later institutes a cap rate of, for example,
4%, the EIA's gain would become even lower. And, if the index doesn't
gain anything, the investor will receive no interest and will lose 12.5%
of the premiums paid. This reality is not what investors think they are buying.
The Differences Between EIAs
As if that is not complex enough, the matter is further complicated by
the many, intricate differences between EIAs that can render comparisons
between them virtually impossible.
These differences between EIAs may include the following:
- The index on which the EIA is based;
- The length of the contract term;
- The participation rate, and the insurance company's ability to change it;
- The spread/margin/asset fees, and the insurance company's ability to
- The interest rate cap, and the insurance company's ability to change it;
- The indexing method, which determines the change in the index over the
period of the annuity and impacts the calculation of the interest credited
to the EIA; and
- How the interest is calculated and whether simple or compound interest is paid.
Some of these differences can drastically affect an investor's return.
For example, one EIA may pay simple interest while another pays compound
interest. The investor would be better off choosing the compound interest
EIA, but that difference may be exceptionally hard to detect from the
disclosures and documentation provided by the sellers.
On the other hand, one EIA might average the linked index's value monthly
while another uses the actual value of the index on a specified date.
The EIA that averages the index's value will likely produce lower
returns for the investor. But again, it is unlikely that an investor will
be able to determine these differences from the materials provided by
the insurance companies.
The Potential for Loss with EIAs
Contrary to the marketing materials, an investor can lose a significant
amount of money in an EIA. First, an EIA is a relatively illiquid, long-term
investment and an early surrender can mean substantial surrender charges
(not to mention a 10% tax penalty, if an investor withdraws funds from
a tax-deferred annuity before he or she reaches the age of 59.5. Second,
an EIA's worth is associated with the credit worthiness of the insurance
company that sells the EIA.
As FINRA warns, "Your guaranteed return is only as good as the insurance
company that gives it."
If the insurance company fails, as many have since the financial crash,
the EIA could become worthless. Despite these complexities, EIAs are marketed
to investors as if they are purely beneficial products. Investments that
require such a high degree of explanation and disclaimers, however, are
rarely appropriate for most people. In our experience, the investors who
have purchased these products have no idea of the effects of the small
print, the costs, or the illiquidity of EIAs. In our opinion, they are
simply too complex for most investors.
Additionally, while EIAs promise market-like returns that are tied to a
particular stock market index, investors often don’t receive the
actual index return. Buried in the fine print of many EIA contracts, investors
will find that dividends are excluded from the index return. This substantially
reduces your return over a long period of time. Many EIA contracts also
set an annual cap on the index return, thereby limiting your gains in
those years when the market index does particularly well. EIAs are frequently
positioned to seniors and retirees who need current income, but there
are many other low-cost options available that do not require you to tie
up your money for several years. Be sure to read through all the terms
and consider all the costs before investing in any EIA.
If you think you’ve received inappropriate advice concerning an EIA
or suspect other forms of investment malpractice, call the
investment attorneys at Meyer Wilson for a free consultation. Just give us a call today or
fill out our confidential online contact form for more information.
You can also learn more about annuities by watching Attorney Dave Meyer's