The Inside Scoop On Why Equity Indexed Annuity Problems are a Disaster for Consumers
Investor education is critically important to us at Davidson Capital Management. It’s the main reason we host our Money Wise radio show and podcast, and why we use our blog to educate our readers. Today’s topic is Equity Indexed Annuities (EIAs), and it’s so important to learn the truth about these dastardly products, especially given some truly misleading marketing campaigns we’ve seen and heard recently.
We believe all annuities are a disaster, so consider this your blanket warning. Today, though, we’re discussing our disdain, distaste, and dislike for Equity Indexed Annuities in particular. In this article, learn some of the common indexed annuity complaints and other issues with annuities.
What is an Annuity?
Let’s start at the beginning here. An annuity is a contract between you and an insurance company, in which the company promises to make periodic payments to you starting immediately or at a time in the future. The keyword here is “promise.” It’s NOT a guarantee, even though the annuity sales industry is permitted to use the g-word in their marketing pitches. It gives consumers like you a warm and fuzzy feeling of protection, but it’s not accurate. We’ve said it before and we’ll say it again: There is only ONE guaranteed investment available, and that is U.S. government bonds, bills, and notes.
The pure definition of the word annuity is a fixed amount of money paid over time. For our clients, an actively managed asset withdrawal strategy from their portfolio creates a fixed amount of money paid over time, but with the huge benefit of not owning an annuity. When a customer buys an annuity they are locking away a lump sum of assets that can only be accessed through the periodic payouts. If a customer has a financial emergency or the periodic payout is not enough to keep up with their living expenses due to monetary inflation, they are out of luck.
An annuity restricts the flexibility of assets in retirement. Maintaining asset flexibility is the main key to a successful retirement. With that said, an annuity owner always has the right to surrender their annuity, but the cost of doing this will be substantial due to annuity surrender fees. Annuities of all types pay some of the highest sales commissions in the financial service industry so do not be surprised when an annuity is the first thing being sold to you by an insurance salesperson or a financial advisor.
Types of Annuities
Annuities can be deferred or immediate, and there are several different types:
- Fixed Annuities. With this type, the insurance company “guarantees” both rate of return and payout.
- Variable Annuities. The rate of return with this type of annuity product is not stable. It varies with the stock, bond, or money market funds you choose as investment options. There is no guarantee you will earn any return, plus you have the risk of actually losing money on a variable annuity contract.
- Equity Indexed Annuities (EIAs). Also referred to with the new marketing term “hybrid annuities,” this is a particularly dastardly type of product. It is very heavily marketed at the moment, and salespeople are making outrageous claims about their benefits.
Since advertising for EIAs is everywhere right now, let’s take a moment to explore more about them.
Equity Indexed Annuity Problems
The reason EIAs are often referred to as “hybrid” is because they have characteristics of both fixed and variable annuities. Their returns tend to vary more than those of a fixed annuity, yet not as much as a variable annuity.
Understanding the ‘why’ of the rise of EIAs is critical because it sheds light on a piece of the puzzle that an annuity salesperson will never tell you. This type of hybrid annuity was created in the late 1990s to compete against certificates of deposit (CDs). Now, if you know anything about the rate of return on CDs that should tell you right off the bat that your rate of return with an EIA will be low – regardless of any sales pitch you may be hearing.
Will you get returns slightly higher than you would with a CD or with a fixed annuity? Maybe. However, when you get into the guts of how equity-indexed annuities are composed, you’ll see that they are a horrible, illiquid product that you should avoid like the plague.
EIAs offer a guaranteed minimum rate and an interest rate linked to a market index, usually the S&P 500. Your index-linked gains depend on the combination of indexing features that the EIA uses. The EIA salesperson will talk about the participation rate or, simply put, what percentage of the linked index’s return will be used to calculate your monthly credited interest. But due to the complex, convoluted mathematical formulas explained over multiple pages of an annuity prospectus, a 100% participation rate in the S&P 500 index does not mean the EIA is credited with 100% of the return for that time period. EIAs do not credit dividends for the index they are tied to so an EIA owner is guaranteed to lose 1%-2% per year in returns. The dividend paid by the linked indexes goes straight into the pocket of the EIA providers.
Of course, most salespeople pull you in with “teaser rates” that only last one year – then they can pull the rug out from under you and adjust your rates without even notifying you. (It’s all in the complex, convoluted fine print of your 100-page prospectus.) Salespeople also use “bonus” payments to lure prospective customers into buying EIAs. But if an EIA performed as well as the salesperson claims it does, why would a “bonus” need to be paid?
What the Salespeople Will Never Tell You
It’s not just the teaser rates that contribute to so many consumers getting taken by annuity salespeople. When someone is trying to sell you an annuity, and particularly an EIA, you’ll only get half the story. Be wary anytime you hear something like, “You get all the upside of the market and none of the downside.” It’s simply not true. Think about it – why would an insurance company sell a product that will always benefit the consumer rather than their own company? They won’t. They don’t. The insurance company and the EIA salesperson are pocketing as much as 20% of your investment, and they make even more on the back-end if you try to get out of your EIA contract early (more on that later).
Here are a few more pieces of the puzzle that salespeople never seem to mention:
Costly Surrender Charges & Poor Liquidity
If you surrender an EIA early, there is a significant surrender charge, sometimes as much as 20%. What does early mean? Well, the fine print of most EIAs will say its surrender period is anywhere from 10 to 17 years! Obviously, these charges will reduce or eliminate any returns you may have otherwise had.
What happens if you need to access your money prior to that long surrender period? Well, you can always take out a 10% free withdrawal with no penalties. However, anything greater than that will trigger the charges discussed above. Clearly, EIAs have extremely poor liquidity, which you need to remember.
There are also tax consequences you need to be aware of for early withdrawals. If you’re pre-59.5 years of age and you’re funding any annuity with after-tax dollars, know this:
If you take out any money (whether a full surrender, a 10% free withdrawal, or other withdrawal) a portion of those dollars will be considered as gains and taxed as ordinary income. In addition, you would have to pay the 10% early withdrawal penalty. None of these detrimental tax consequences are explained by the salesperson upfront. They sell based on half-truths, never telling you the consumer the bad part of the story.
Here’s one that has surprised many a policyholder – the insurance company actually caps the upper limit of your returns. It’s generally stated as a percentage, buried deep in the pages of your prospectus. So, let’s say your max is 4% per month, which is not uncommon for an EIA. That means that, if the market goes up 10%, you’re still capped at 4%. That is the maximum amount of credit that can be credited back to your account.
Insurance companies use a very complicated mathematical formula to determine how much you make in returns, and you can be sure it’s not to the benefit of the policyholder – it’s to the benefit of the insurance company.
No FINRA or SEC Protections
An equity-indexed annuity is an insurance contract – a product – not security. That’s an important distinction because it means the Financial Industry Regulatory Authority (FINRA) and the U.S. Securities and Exchange Commission (SEC) do NOT police these products. State boards of insurance must police them instead, and many are very much behind the curve. Even more concerning is their lack of serious recourse against a company committing a violation. EIA marketing campaigns can ostensibly say whatever they want and, if it turns out not to be true, they get a minor slap on the wrist. (Believe us when we say companies take advantage of this, too. Back in 2005-2006, we reported a company to the state board of insurance here in Texas because they committed 26 separate violations in a one-hour radio show marketing EIAs.)
The Myth of the Guarantee
Salespeople will also never tell you that the word “guarantee” used in their marketing and sales pitches really means “promise.” Any promise you receive from an insurance company is only as good as the company that wrote the contract. And… what happens if the insurance company you’re doing business with fails?
Well, here in the State of Texas, we have a state insurance trust in case an insurance company goes out of business. However, what most people don’t realize is that the maximum restitution you can receive if an insurance company you had assets with goes belly-up is $250,000. So, if you had $500,000 invested in an annuity and the company folded, you would be out $250,000.
If you’re thinking that sort of thing is unlikely to happen, think again. This is exactly what would have happened to thousands of AIG clients during the 2008 financial crisis if we, the taxpayers, hadn’t bailed them out with a bridge loan of $186 billion to cover their books. If that hadn’t happened, the annuity business as we know it would be dead – but you never see any media stories about that, do you? It needs to be discussed, so we do it here.
Final Thoughts on the Dangers of Equity Indexed Annuities
Annuities, in general, are sold based on fear – and this is particularly true of EIAs. Unfortunately, the 2008 financial crisis and stock market volatility have done nothing but bolster annuity sales because the insurance companies prey on investor fear and discomfort.
EIAs are extremely complicated in order to keep purchasers in the dark. You almost can’t even ask questions because they are so complex and opaque. Insurance companies don’t want you asking questions, which is why annuity salespeople target the financially unsophisticated and the elderly. They want to sell you a narrative that is a half-truth at best and an outright lie at worst. That’s why we’re so passionate about giving you the full truth about these dangerous products.
Remember, there’s no such thing as a free lunch. If something seems too good to be true, it is. If you’ve even had a fleeting thought about buying an EIA or any annuity, please pick up the phone and call us. In just 15-20 minutes, we can better educate you so that you won’t make a poor choice that will harm your financial security significantly.