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 change them;
- 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 video below.