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How Equity-Indexed Annuities (EIA's) Actually Work: A Case Study

According to the Life Insurance and Market Research Association, an industry trade group, sales of indexed annuities (also known as fixed-index or equity-indexed annuities) are surging.  Apparently, sales of this product have risen 230% over the past decade or so.  As more insurance companies enter this market and as hiring of annuity salespeople picks up, sales of indexed annuities are expected to hit a record high this year.

And who could blame all these investors for being attracted to a product touted as having protection from any downside in the stock market as well as participation in its upside?  Especially with painful memories of the bursting of the tech stock bubble and of the more recent housing-related financial crisis still fresh in Baby Boomers'  minds.

I've written before in our blog, Articles on Wealth Management Topics, that buyers often seem unaware of the shortcomings of annuities until well after their purchase. Equity-indexed annuities are no exception to this statement.  While the downside protection they offer is not at issue here (but is subject to the claims-paying ability of the insurance company involved), the upside potential of these products is often vastly exaggerated (or misunderstood) by salespeople motivated by nothing more than the prospect of sales commissions averaging about 6% of the amount invested.

(If you've ever received an invitation in the mail to a retirement or investment seminar that included a free dinner, and wondered about the economics of this marketing ploy or what the "catch" is, the "seminar" most likely included a sales pitch for an indexed annuity.  It doesn't take many 6% commissions to cover the cost of a few dozen entrees.)

What is an Indexed Annuity?

To keep it as brief as possible, an indexed annuity is an annuity in which the investor's account is credited with interest based upon the performance of a specified stock index, e.g. the S&P 500 index.  The actual methodology or mathematical formula that determines how the performance of the stock index translates into actual interest earned is laid out in each annuity contract and varies widely.  In general, though, in return for a guarantee against loss of principal or even a small guaranteed interest rate, the annuity holder gives up at least some (and usually most, as we shall see) of the upside in the underlying stock index.

This sacrifice of upside is imposed by the issuing insurance company in one of several ways that include:

1. Participation rates - a participation rate expressed as a percentage less than 100 is imposed on the return of the index, e.g. the investor will receive 80% of the return of the S&P 500.

2. Index Spread or Margin - a fixed number of percentage points is subtracted from the return of the index, e.g. the investor will receive the percentage return of the S&P 500 index less 3 percentage points.

3. Caps - an upper limit is placed on the return that will be credited, e.g. the investor will receive at most 6% regardless of how much the S&P 500 index returns beyond that threshold.

Because indexed annuities are very complex and because their high commissions invite abuse of investors by less-than-scrupulous salespeople, the Financial Industry Regulatory Authority (FINRA) has issued an Investor Alert on EIA's.  FINRA's web page also describes annuities in more general terms, discusses EIA crediting methodologies in more detail, and addresses some frequently-asked questions about indexed annuities.

An Actual EIA Case Study Involving a Five Seasons Financial Planning Client

Rather than continuing to debunk the inflated and self-serving claims of EIA salespeople in an abstract way, let's look at an actual contract owned by a client who came aboard last year.  This is an excerpt from the actual annuity contract provided by the insurance company to the client (please excuse the chicken scratches that are my original notes).

Among the first things you'll notice is that the Participation Rate in this Example provided by the insurance company is 90%.  You'd be forgiven, then, as a prospective investor in this annuity (if you had endured through the first 19 pages of disclaimers and explanations) for concluding that your annuity return would be something like 90% of that of the S&P 500 Index in up years for the stock market.

But as the FINRA Investor Alert makes clear, the Indexing Method of a given annuity (i.e. Annual Reset, High Water Mark, Point-to-Point, and so on) also has a tremendous impact on the interest actually earned by the investor.  As a result, even in a hypothetical year in which the S&P 500 Index rises by 24%, Year (i) in the Examples provided, and with a participation rate of 90%, you as the investor would earn a paltry $234 on your $10,000 investment, a return of only 2.34%.

This Indexed Annuity is Even Worse Than it Looks

To be fair, in the following hypothetical year, Year (ii) in the Examples provided, this annuity does serve its purpose by generating a 2.29% return in a year when the stock market falls 19.4%.  And in Year (iii), you would be credited with a return of 2.23% while the price return of the S&P 500 is zero.

But to give you some further perspective on these meager annuity returns, keep in mind the following:

- In 2005, when this annuity was bought by Client, 1-year CD rates averaged 2.77%.  So in the worst market year in the Examples provided, Year (ii) when stocks fall by almost 20% and the annuity shines in comparison, you would have done even better than owning the annuity simply by sticking your money in the bank.

- The participation rate on an indexed annuity is completely at the discretion of the issuing insurance company.  While the Examples display returns assuming a 90% participation rate, Client's actual annuity had a 70% participation rate during the first 10-year term, after which the insurance company lowered it to 20% for the second 10-year term and added insult to injury by imposing a 10% cap.  As an indication of how this further depressed Client's annuity returns, Client's September 30, 2017 annual statement shows that she was credited with a .45% return in a year during which the S&P 500 Index returned 16.2% in price terms.

- Even with the 90% participation rate in the Examples provided, the sequence of years shown there maximizes the 3-year annuity return to the extent possible.  For example, if you reversed the order in which you experienced Years (i), (ii) and (iii), so that the stock market was instead unchanged in Year (i), then fell in Year (ii), and then rose strongly in Year (iii) back to unchanged at the end of 3 years, your total return over the 3-year period would be even lower than the 2.29% annualized rate shown in the Examples provided by the insurance company.

- When we invest in the S&P 500, through an index fund or exchange-traded fund, we receive all the dividend income generated by the companies included within that index.  This "dividend yield" varies somewhat through time, but it is a meaningful part of the total return that we receive as stock market investors.  (For perspective, the dividend yield on the U.S. stock market has been about 2% in recent years and that's about where it is now).  Well, the vast majority of indexed annuity investors receive no credit for dividend yield.  Put another way, for you to have received your 2.34% EIA return in Year (i) of the Examples provided, the S&P 500 actually had to generate a total return (including dividends) of about 26%.  How's that for upside potential, even with an uncapped 90% participation rate?

- Even the downside protection of this annuity is somewhat of a mirage.  For an illustration of this, assume that in the very first year that you own this annuity, the stock market declines dramatically as in Year (ii) in the Examples provided.  Your annuity value at the end of that first year would indeed be what you had initially invested. That is, unless you then decided that you wanted to cash the annuity in, e.g. for unforeseen expenses or simply to redeploy the proceeds into a stock market that has become markedly cheaper.  You would then be faced with forgoing several percentage points of this annuity's value and of your original investment in the form of a surrender charge.  Paying the surrender charge in this instance would in effect be the end of your downside protection.

Making Lemonade Out of Annuity Lemons

Many years ago, when I first became aware of indexed annuities, I wondered why Fee-Only financial advisors (who can't sell them and rarely recommend them), and academics alike, regard these products as substitutes for bonds and even for CD's rather than as a conservative way to gain exposure to the stock market.  After all, the interest received by an EIA owner is a function of stock market returns, however flimsy that relationship might be.

And while the inner workings of the indexed annuity product we've been discussing in this case study crossed my desk by happenstance last year, I have no doubt that there are better indexed annuities available in the marketplace (and probably even worse ones).  Nonetheless, it should be clear by now that if you believe the prevalent marketing pitch that an indexed annuity is an investor's magic bullet, that this product allows you unqualified protection from stock bear markets and significant participation in stock bull markets, then you are are likely to be very disappointed.

It's telling that the indexed annuity market has experienced a growth spurt in the few years since the Department of Labor's fiduciary rule was overturned.  Any financial product, that is recommended and sold more once investors' best interests are no longer legally required to be the primary consideration, deserves tremendous scrutiny. However, I've written before that some forms of annuities may have a role to play in a retirement portfolio and that there is such a thing as a cost-effective and well-engineered annuity.  Happily, there are often ways to extricate yourself fairly painlessly from an unwanted or suboptimal annuity, to make lemonade out of a lemon in other words, and that's what we did for the Client in this case study.

About the Author

Paul Winter, MBA, CFA, CFP® is a Fee-Only financial advisor and fiduciary in Salt Lake City, UT. His independent wealth management firm, Five Seasons Financial Planning, provides professional portfolio management and objective financial planning services to individuals and families, and to their related entities including trusts, estates, charitable organizations, and small businesses.

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