The lure of having principal protection and some upside growth with a tax-deferral makes many investors consider an Equity Indexed Annuity, but buyers should beware and exercise caution before buying an annuity or other insurance product as a substitute for an investment. Take notice that many financial commentators from highly regarded publications such as Forbes, Bloomberg, Business Week, Financial Planning and other national publications have been very critical of Equity Indexed Annuities, for many of the reasons that we will explore in this article.

In addition to such negative financial press concerning Equity Indexed Annuities, on September 13, 2010, the Financial Industry Regulatory Authority (FINRA), the federal regulatory agency and oversight board of stockbrokers, issued an “Investor Alert” concerning Equity Indexed Annuities. This alert is eerily similar to alerts issued on other types of annuities by the Securities and Exchange Commission and the State of Michigan Office of Financial and Insurance Services. Indeed, on December 1, 2005, the State of Michigan issued an unambiguous warning letter to the public on annuities entitled, “Seniors Beware: Variable Annuities May Not Make Sense For You!”

So who is selling Equity Indexed Annuities and what are the downsides of such insurance products? With the helpful assistance of our colleague and prolific nationally recognized author on investment planning, Larry E. Swedroe, MBA, we hope to address these important concerns about Equity Indexed Annuities.

Equity Indexed Annuities are sold by insurance agents

A recent estimate finds that 95 percent of all Equity Indexed Annuities are sold by insurance agents and not investment advisers. This should be a concern to the investing public for two reasons: (1) insurance agents often lack substantial education, training and experience in investment, tax and estate planning and; (2) because Equity Indexed Annuities are an insurance product they were, until recently, not even regulated or controlled by the Securities and Exchange Commission (SEC). The SEC is the federal agency with oversight of investments and investment advisers but not generally of insurance products and insurance agents, which are left to state regulation.

Investors may not receive returns comparable to the index

A typical Equity Indexed Annuity provides less than 100 percent of the index’s return. Several restrictions may be used to decrease the expected returns to investors, six of which are discussed here.

1) Participation rates. Equity Index Annuities typically have participation rates below 100 percent. According to the NASD (predecessor to FINRA), “A participation rate determines how much of the gain in the index will be credited to the annuity.”

2) Annual cap. This is the maximum rate at which the Equity Index Annuity can be credited. This means that there is an upper limit on possible returns. For example from an up year, although the S&P 500 Index rose almost 29 percent in 2003, an investor with an Equity Index Annuity capped at 11 percent would only have been credited for that amount, instead of receiving the actual gain of the index linked to the Equity Index Annuity.

3) Change in the index. Another method of keeping the payouts lower is to credit an investor with the price-only change of the index, not with its total return. Thus, the return received from an S&P 500 Index fund will be greater than the change in the index by the amount of the dividends received.

4) Spreads. Use of a margin called a spread can also reduce payouts.  If this feature is part of an Equity Indexed Annuity, the return would be determined by subtracting a percentage from any gains made by the index.  For example, if the index gained 9 percent, an Equity Indexed Annuity with a spread of 3 percent would receive 6 percent.

5) Interest. The Equity Indexed Annuity may credit its return based on simple interest, instead of compound interest.

6) Calculations. Instead of basing the return on the actual change in the index, the calculation of return is sometimes based on the change in the average daily closing price of the index throughout the year. Consider this example. The index begins the year at 10,000 and ends the year at 12,000 (a gain of 20 percent), increasing in a perfectly straight line. The average price during the year would then be 11,000, but investors would be credited with a gain of just 10 percent.

Different methods for determining how interest is credited to an Equity Indexed Annuity

Several methods by which the amount of change in the relevant index is determined include the following:

Annual reset (or ratchet) – Credits the Equity Indexed Annuity with index-linked interest.

Point-to-point – Credits the Equity Index Annuity index-linked interest based on any increase in index value from the beginning to the end of the insurance contract’s term.  This method relies on a single point in time to calculate interest, which is typically a disadvantage for the investor.

High water mark – Credits the Equity Indexed Annuity index-linked interest based on any increase in the index value from the beginning of the insurance contract’s term to the highest index value at various points during the insurance contract’s term (often the annual anniversary).

When minimums are not minimums

Typically, Equity Indexed Annuities come with a guaranteed minimum return of at least 3 percent.  However, that guarantee is not always on the entire investment.  More often, the company guarantees that the investor will receive 3 percent on just 90 percent of his or her investment. The result is that investors can still lose principal investing in an Equity Indexed Annuity, especially if they need to cancel their annuity early.

Penalties for early withdrawal

Equity Indexed Annuities can have significant early surrender charges. Some charges have been assessed at higher than 20 percent of the insurance contract value.

Tax inefficiency

Equity Indexed Annuities are often sold for the “tax-advantage” (tax-deferral) feature. First of all, this tax deferral component is absolutely unnecessary for Individual Retirement Accounts (IRAs) and Roth IRAs. There is no tax benefit for purchasing a tax-deferred vehicle with all of its attendant costs and other disadvantages, simply to place it in a tax deferred IRA. Second, these so-called “tax-advantaged” annuities are actually “tax-nasty.”

Equity Indexed Annuities are taxed as ordinary income (not the favorable long-term capital gains tax rate), which is the investor’s highest marginal tax bracket, and are generally subject to a 10 percent tax penalty on any withdrawals before investors reach age 59½.  As to beneficiaries receiving proceeds from an annuity there is no step-up in basis with an annuity and, if that were not challenging enough, the taxable proceeds of an annuity will be subject to the higher ordinary income tax rates.

Additional disadvantages

Equity Indexed Annuities also carry credit risk in that their values and guarantees are only as good as the credit of the companies providing the guarantees.  The fear is that during severe bear markets (when the guarantees are most valuable), the insurers’ ability to honor the guarantees may be in question.  This was seen in 2008 when market conditions triggered downgrades in several insurance companies’ credit ratings. 

		Stephen L. Hicks, JD, MS, CPA and Roger L. Millbrook, JD, CPA/PFS, are fee-only fiduciary investment advisers and principals of Siena Capital Management, LLC. Part of a larger Siena team, both professionals are lawyers and accountants and hold advanced degrees or designations in the area of financial services. Siena was recently listed by CPA Wealth Provider Magazine as one of the Top Investment Advisory Firms in the United States. Siena is the only investment firm headquartered in mid-Michigan to make the exclusive list. Siena advisers can be reached at info@sienainvestor.com.