Index Annuties - What You Are Not Told

Sales pitches on equity-indexed annuities don't point out down side 
by Humberto Cruz, South Florida Sun-Sentinel 
Published July 20, 2005 
It is "the best of both worlds," the sales pitch goes, "an investment that goes up with the stock market but does not go down!"

No wonder sales of these "equity-indexed annuities" -- a type of tax-deferred fixed annuity that pays interest rates based on stock market returns, but with a guaranteed floor -- are taking off. Nationwide, sales set a record -- $23.1 billion last year, up from $14.4 billion in 2003, according to the industry group LIMRA International.

Equity-indexed annuities may indeed be appropriate for conservative investors with realistic expectations and no need to tap their principal for several years. But despite their apparent simplicity (they can go up but can't go down), these annuities are complex products often touted at "investment seminars" by commission-motivated agents who don't fully understand or fail to disclose potential pitfalls.

Like me, "I do not hate these products. But I hate the way most are presented," said Thomas Hamlin, founder and CEO of Annuityfyi.com, an online investor guide and product-comparison service. Because equity-indexed annuities are not considered securities (at least not yet, but regulators are looking at this issue), sellers don't need a securities license and insurance companies do not have to provide a prospectus detailing risks and costs.

"Most people think when they buy these things that they are going to keep up" with gains in the stock market, but they are not, Hamlin said. "Not only that, but they are going to underperform a good corporate bond in most cases."

Here is why. Equity-indexed annuities credit interest based on the return of a market index, such as the Standard & Poor's 500. But that interest rate is typically subject to a cap (a maximum, no matter how high stocks go), a participation rate (a percentage of the gain of the index), or a spread (an amount subtracted from the index's gain). Also, index gains from dividends are typically not included.

"There is so much to understand, and it is extremely hard to make apples-to-apples comparisons because from one contract to the next the features are so different," said Ronald Myers, a certified financial planner in Plantation.

Perhaps the most critical thing to understand is the "crediting method" used to calculate the interest rate. One prevalent today (among many) is the monthly "point-to-point" with a cap. You take the percentage change in the value of the index each month for a year and add up the 12 figures (a monthly loss is a negative number). The result is the interest rate you get for the year, but never less than zero.

The catch is that each monthly gain is subject to a cap (such as 2.6 percent in a top-selling product today). A 5 percent gain one month counts only 2.6, but a 5 percent loss counts minus 5. Using this method, I calculated an investor would have received 5.09 percent interest in 1999, a year the S&P 500 returned 21.08 percent.

Conclusion: Before buying, insist on being shown how the annuity would have performed in different time periods using the least favorable terms allowed in the contract.

Commissions are another issue. Although equity-indexed annuities are touted as having "no fees," the average commission to the seller runs between 8.5 percent and 9 percent, according to Timothy Pfeifer, an actuarial consultant with Milliman Inc.

The cost of the commission is built into the annuity terms, including usually steep surrender charges (I have seen as high as 22 percent) if you cash in the annuity before a set number of years. These charges can come as a surprise to investors who did not pay attention before buying or were not told the whole story.

"We've seen too many people fall victim to unscrupulous salespeople," said John Hargrove, an attorney whose firm represents elderly investors in Florida in class-action lawsuits against American Equity Investment Life Insurance Company and AmerUs Life Insurance Co. The main complaint is that agents "trained in the techniques of selling rather than the nuances of the product itself" misled investors into believing these annuities would provide them with retirement income while in reality investors faced surrender charges for several years, sometimes beyond their life expectancy.

In the case of American Equity, U.S. District Judge Patricia Fawsett in Orlando approved a settlement in February calling for improved training of agents and some financial benefits to the annuity investors. The case against AmerUs has not been heard. A spokesman for AmerUs told me that while the company cannot comment on pending litigation, "we believe we have very strong defense against this suit."

Copyright © 2005, South Florida Sun-Sentinel Our thanks to the Sentinel and Humberto Cruz for allowing Money Bulletin to reprint this objective commentary that benefits consumers.