Index Annuities - Ball Of Confusion
BOSTON (MarketWatch) Feb 10, 2005 -- It's billed as the ultimate
have-your-cake-and-eat-it-too financial product, an investment that returns a
share of the stock market's gain with no risk to your principal.
So-called equity-index annuities provide a minimum guaranteed return and
safety of principal, plus upside potential. So it's no surprise EIAs, as
they're known, are increasingly popular among older investors wary of the
market's ups and downs yet fearful of missing the next bull market rally.
Indeed, EIA sales reached nearly $22 billion last year from nearly nothing in
1995, according to St. Louis-based industry tracker Advantage Compendium. Its
president, Jack Marrion, says at least six major insurers plan to launch EIAs
this year, joining nearly 40 others, including market leaders Allianz Life,
AmerUS Group, American Equity, Midland National Life and Fidelity &
Guarantee.
"Sales are booming because people have been terrified of the volatility
in the stock market," says John Olsen, head of the Olsen Financial Group
in Kirkwood, Miss.
Yet EIAs are among the least understood and most oversold products in America
today, Olsen says. And they bear an often overlooked risk -- they're dependent
on the financial strength of the insurance company offering them.
"A lot of sales are not proper," Olsen says. "A lot of agents
sell EIAs as an alternative to stocks or to bonds or CDs and that's not
appropriate.
"It's a fixed annuity and annuities are not investments. They are
risk-management products. They are not alternatives to bonds because they
don't act the same. They are horribly complicated."
Yes, EIAs come with standard fixed-annuity features such as minimum
interest-rate guarantees and surrender charges. "But the product is more
complicated to understand," says Raj Shah, a managing senior financial
analyst with A.M. Best, an insurer-rating firm that just issued a cautious
outlook on insurers in the EIA business.
Caveat emptor
Shah says here are several major elements you need to understand before buying
an EIA:
- The minimum guaranteed rate: That's the rate of
interest the insurer guarantees to give you, the contract holder. The
minimum rate currently ranges between 1.5 percent and 3 percent, typically
on 90 percent of the initial premium deposit. But Shah says many insurers
are lowering the base upon which the guarantee applies as a way to improve
profitability and reduce some of the risk that comes with selling EIAs in a
low-interest-rate world.
- Participation rate: This is the rate at which
you, as EIA owner, share in the upside of the equity index being tracked,
typically the Standard & Poor's 500, but increasingly other indices as
well. Typically, the rate (say 55 percent of the S&P 500 minus the
dividend) is set when the EIA is issued and guaranteed for one year. The
participation rate will depend on interest rates and the cost of call
options.
- Spread deduction: This is the fee charged by
insurers for their expenses. Usually, it's deducted from the percentage
increase in the equity index being tracked.
- Return cap: This is the maximum rate that can be
credited to an EIA owner's account, regardless of the actual market returns.
Typically, that cap is set low such that an EIA owner can expect to earn the
minimum guaranteed rate, say 2 percent currently, plus another 2 percent
when the stock market rises -- 4 percent overall.
- Index-crediting methods: Insurers use various
formulas to calculate the equity index's return for your EIA. The most
common method is the annual reset-averaging index, but there are others.
And if all that wasn't hard enough to figure out, insurers keep adding bells
and whistles such as bonus interest rates or teaser rates to EIAs. Conseco,
for instance, launched an EIA this week that comes with a 7 percent first-year
bonus rate. Of course, as with most things in life, there is no free lunch.
Many EIAs with bonus rates also come with hefty long-term surrender charges.
Due consideration
So what's the bottom line on whether and when to buy an EIA and what to look
for? For his part, Marrion says EIAs work best for those saving for
retirement, in the so-called accumulation phase of their lives, and who do not
have to touch the money during the surrender-charge period.
Says Olsen: "People need to understand that these products, even if they
have nursing-home riders, are not liquid."
EIAs also work best if viewed as being a part of your fixed-income portfolio
rather than your equity portfolio, despite their name, Marrion says.
"Remember, you are not getting all of the (equity index's) upside."
Olsen says EIAs need to be viewed as a risk-management product, not an
investment. For instance, he says preretirees should consider investing a
portion of their stock-market gains in EIAs to protect their principal and
still participate in the market. They tend to work best in a choppy market, he
says.
And preretirees should evaluate the integrity of the person selling the EIA
before buying one, Marrion says.
"These products are sold not bought," he says. "So if it's
being pitched as an alternative to stocks, if it's being pitched as
you-get-all-of-the-gains-and-none-of-the-losses product, walk away."
Of note, EIA sales are regulated by state's insurance commissioners, not the
SEC or NASD. And for some that creates the potential for sales abuse. Often,
agents are given incentives to sell such products, and typically it's the
products that offer too-good-to-be-true rates that come with the greatest
commissions.
Olsen also says there's more myth than reality to the statement that EIAs have
no risk. "To say that there's no downside to these products is simply
nonsense," he says. "There are surrender charges plus there's
opportunity cost."
And though impossible to evaluate the financial strength of the individual EIA
being sold, experts say it's vital that you evaluate the financial strength of
the insurer behind the EIA.
For his part, Olsen recommends buying an EIA from a firm that has either the
best or next-best rating from at least three of the major rating services.
Others such as A.M. Best's Shah says it's OK to do business with a firm that
has a "secure" rating from his firm, those with a B+ or better
rating.
He also suggests that potential EIA buyers ask for a live illustration of the
product's performance. "One really has to do their homework," Shah
says. "You can't simply rely on the agent. They will only talk about the
good side of the product."
