Avoid Index Annuities

Posted by Keith on May 4, 2007 at 12:59 pm  


Our adviser has recommended that we invest in something called a market index annuity. He says we’ll receive the greater of two alternative returns: Either the growth in the S&P, just as if we had bought an S&P Index fund;, or five percent per year, whichever is greater.

Our adviser says a lot of people are investing in these annuities. It sounds almost too good to be true. What can you tell us about market index annuities?


Keith Responds from aboard The Global Adventure, approximately 130 miles SW of Honolulu, en route to Majuro, Marshall Islands:


Don’t buy them! Your adviser is correct on one point: Everyone and their brother is selling these things. And, unfortunately, consumers are falling for the pitch. Why are they being sold so aggressively?

(A) Because they often pay HUGE commissions to the adviser; and

(B) Because you do not need a securities license to sell them. You only need an insurance license.

This means that every Tom, Dick, and Harry with a life-health-disability insurance license can wax fantastic about the benefits of a complex securities-based product they often – and I do mean often – do not understand.

Frankly, even advisers with securities licenses are often too distracted by the high commissions here to worry about the pesky little details of the product. Here is what most such advisers rarely mention:

Percentages and Caps: You will only participate in a portion of any market increase, and your participation will be capped. Here’s how it works:

Mom and Dad purchase an S&P Index market annuity. During the next 12 months the S&P grows by, say, twenty percent. Mom and Dad are excited. They think they’ve enjoyed a twenty percent return on their investment!

Actually, these products always limit Mom and Dad’s participation in any market increase to a percentage of that increase – often seventy or eighty percent. And, Mom and Dad’s participation in any increase is capped at about ten percent annually.

Therefore, in a year when the market rose twenty percent where Mom and Dad’s participation is capped at ten percent, they will participate in only half the total return of the index.

It’s Worse Than You Think: And it gets worse in two ways – thanks to what I believe are truly misleading math games insurance companies play as they create these products:

The Games They Play: First, these companies know, as do most experienced licensed securities advisors, that the markets depend on outsized years – gains of more than, say, fifteen percent – to achieve their historic average return of – in the case of the S&P – about ten percent. When an investor’s participation is capped at only the historical average return, he will not participate in those outsized gains when they occur. In short, if the very best you can do is ten percent, then your return automatically will be significantly less than that over time. What’s more, your “participation” on the down side is not capped. Therefore, if over a ten-year period, you had three outsized years (where your participation is capped,) four average years (where you receive only a percentage of the gain), and three down years where the full extent of the loss will be averaged into your presumed total return in calculating your “market return” over time, your total return over time is going to be very, very disappointing.

Dividend Reinvesting Ignored: Second, most of these annuities use as their benchmark only the straight growth of an index. They do not include the value of growth on reinvested dividends. I have never calculated this myself, but I have read numerous times that, long term, more than half the growth of indexes such as the Dow and the S&P are based on the growth of reinvested dividends. Incidentally, this percentage would not be as high in a NASDAQ index since fewer companies there pay dividends. Obviously, this approach greatly reduces the overall gain in which the annuity owner participates. And remember, the investor only receives a percentage of this reduced – non-reinvested-dividend amount.

Internal Charges and Surrender Fees: Although, according to the sales pitch, you are only investing in a market index – a form of investing that might cost only 15 bps (15/100ths of a percent) per year anywhere else, your annual fees within these annuities are often as high as three percent.

Admittedly that three percent also pays for the mortality charges associated with the death-related guarantees inside all annuities; but it is also used to recover the annuity company’s “marketing expenses” – translation: to reimburse the company for the huge commissions it paid the advisor who sold you the annuity.

It’s All Related: Those high commissions, your lengthy surrender period, and those very high surrender charges are all related.

Commissions and Surrender Periods: First, most index annuities require you to stay with them for at least ten years. I’ve even seen surrender periods of 15 hears. You may safely assume that your advisor will receive a commission of one-percent-per-surrender-period year times your invested amount. So if you put, say, $250,000 into an index annuity with a ten-year surrender period, your advisor will probably receive a check for $25,000. Not bad for a day’s work, eh? While this commission does not come out of your initial invested amount, it certainly increases your annuity’s annual fees, as the issuing company recoups a portion of that marketing expense each year.

Those Surrender Charges: Most annuities, including index annuities, permit you to retrieve up to ten percent of your initial invested amount annually, without penalty; and they will also permit you to take mandatory IRA distributions without penalty if you are 70½ or older. However, for all other withdrawals, they will charge a surrender fee during the surrender period. A conventional variable annuity with a seven-year surrender period, usually charges a declining surrender fee of seven percent the first year (not-so-coincidentally seven percent is the customary commission), six percent the second year, five percent the third, etc.

However, index annuities typically charge much higher surrender fees. Their “declining” surrender fee schedule might look like this: A ten percent surrender fee in years 1-5, a seven percent surrender fee in years 6-7, and a three percent surrender fee in years 8, 9, and 10. These high fees have the desired affect: They trap consumers in the product long term so that the insurance company – and not necessarily the investor – can make a serious return.

Adding Insult to Injury: “But,” your advisor says, “we’ll (meaning the insurance company issuing the annuity) pay you five percent per year if your index market return over time is less than that.”

But here is what he didn’t mention: You don’t get to chose from year to year which return you wish to receive. You chose only once, and often you must annuitize the annuity to receive your guaranteed five-percent return. This means you must take your money in annual payments either over your lifetime or over some minimum period, such as ten years. That’s an additional ten years! And even if they don’t require you to annuitize the contract in order to receive your minimum five percent return, that return will likely not be compounded — it will only be paid on the original invested amount, with those same annual payments added up, not compounded.

So Who Really Benefits? Well, the advisor who sold you the product did very nicely, thank you very much. But it’s the insurance company that does about as well as you can do without a gun.

Subject to their mandated reserve requirements, the insurance company is going to do exactly what they said they’d do: Invest in the applicable index, probably through a money manager such as (but not necessarily) Vanguard, for a fraction of the already-low annual retail cost of 15 bps.

They have years to worry about which return option you’ll select; and it just doesn’t matter to them. The index participation formula they are using will virtually guarantee that your “market return” will be somewhere between four and eight percent annually in most up years, and never more than ten percent in the outsized up years. Meanwhile, there is no applicable “cap” or “stop loss” to save you in down years. Your entire loss is factored into the over-time calculation in determining what your total average market rate of return has been. Another way to look at it is this: The insurance company is borrowing your money for ten years at an interest rate of five percent – if that.

So how does the insurance company profit? Let me count the ways:

1. It captures the entire market-index excess on the upside.
2. It captures the benefit of all reinvested dividends, since that growth is typically not part of the calculation for the investor’s share.
3. It assesses extra charges within the policy, not just for mortality guarantees, but also to help fund its promised “guaranteed return.” Rest assured that these charges represent distinct profit centers for the insurance company.

Meanwhile, the insurance company’s risk is tiny. Over any ten year period, it is not likely that a broad market such as the S&P will do much better or worse than its historic average. However, even if the market performs poorly and they must pay you that guaranteed five percent, if they require you to annuitize the contract before you get paid, they then have many more years to work with your money (albeit a declining amount over time) to catch up. And remember: You are paying a premium inside your policy to help the insurance company fund that guarantee anyway.

Far Better Alternatives: First, not everyone belongs in an annuity. However, from an estate planning and preservation viewpoint, they can be very helpful in protecting loved ones. But that’s the subject of another article, perhaps. Meanwhile, good variable annuities issued by top companies seem a far superior alternative to market index annuities.

Check ‘Em Out: Specifically, check out the variable annuities offered by Triple-A-rated insurance companies. These policies are definitely not all the same. READ THE PROSPECTUS. Avoid surrender periods longer than seven years; and be wary of annuities with little or no surrender period. That may sound appealing. However, they often do not provide all the guarantees provided by longer-surrender-period annuities. Yes, these are securities products, and your advisor must have a securities and insurance license to sell them. Do NOT assume your adviser knows all the secrets of the annuity. Call the home office for clarification if you do not receive a satisfactory response to your questions from your adviser.

Remember: I don’t sell securities of any type anymore, so I have no hidden agenda here. I’ll use AIG’s Polaris Annuity as an example. The Polaris annuity:

Permits you to invest in any number of securities sub-accounts managed by some of the top money managers in the world. I believe you can also find index funds within this annuity, if you wish to avoid more actively-managed sub-accounts. Also, you can switch back and forth (within limits) among the funds, including their bond or money market funds, as you deem necessary.

You will automatically receive a death-benefit guarantee that if you manage to lose money over time in your sub-accounts, and then you die, Polaris will pay the policy’s named beneficiary the annuity’s total return, or three percent per year, compounded, whichever is greater. For a tiny additional annual premium you can bump that guarantee up to five percent per year compounded.

What’s more, this product offers a similar “living benefit.” If after seven years your total return in the sub-accounts was less than five percent compounded, they will make you whole. And you are not required to annuitize the contract to receive the benefit. Again, you pay for this additional guarantee, from among a menu of options. Professionally, I sometimes found this a prudent way to protect minimum portfolio values for retired clients who wanted to enjoy the potential growth of equities, while also protecting their standard of living long term.

Don’t Forget Your Free Look: To protect consumers, most states provide for a free look period for all insurance products. In Arizona, the period for annuities and life policies is 30 days, and the period does not start until the completed policy has in fact been actually delivered to you. If you purchased an index annuity, and you are still within your state’s free-look period, or if your adviser was sloppy and never gave you the completed policy (He would have required you to sign a receipt), I would seriously recommend you exercise your right to cancel the policy to receive a full refund.

My Prediction – Law Suits are Next: Remember back in the ’80s how many people lost their shirts in limited partnerships? Remember how many law suits resulted? I predict that starting about five years from now, as the first of the 10-year index annuities fall out of their initial surrender period, we will see another rash of lawsuits by consumers who are extremely upset with the so-called “market returns” they received, and who realize they could have done much better in variable annuities, or investing directly in an index themselves. They will also be extremely upset with the requirements imposed on them in order to receive their guaranteed-minimum return.

As always, the insurance companies will counter by saying that we are responsible for whatever we sign, and that ultimately it is the consumer’s duty to know what they are getting into. Fair enough, except for this one troubling detail:

The insurance lobby has gone to great lengths to ensure that market-index annuities be treated solely as insurance products, and not as insurance-securities hybrids, which in fact is what they, and variable annuities, are. They did this so that their far less sophisticated insurance-only agents would jump at the commission bate and sell these products even if they did not understand them.

If the insurance industry had done the right thing and registered these products as the securities that they are, then perhaps their caveat emptor defense would fly. But in my opinion they have deliberately chosen to sell these products through the least sophisticated marketing channel possible, so that they could pull the wool over the eyes of both their insurance agents and the consuming public.

If I were a litigation attorney, and not, as I like to say, a recovering attorney, this is exactly the type of case I would love to take – on behalf of the hundreds of thousands of consumers who have been, and who are being, duped into purchasing these slight-of-hand smoke-and-mirrors products.

I hope my message here is loud and clear. Stay out of market index annuities!



1 Comment so far

  1. Will Creekmur on May 11, 2007 4:31 pm

    I thought you might appreciate a bit of clarification regarding the “Dividend Reinvesting Ignored” aspect of equity indexed fixed annuities (EIFA). You had me research them in the past, and I remain quite aware of where the downsides can exist for investors, and where they can be both misleading and inappropriate.

    The indexes used are price appreciation indexes, and so, as you stated, changes in the level of the indexes do not include the dividends investors would receive if they owned the underlying stocks or mutual funds. Exclusion of dividends causes the changes in the S&P 500 Index level used in EIFAs to significantly understate the returns earned by investors in the S&P 500, as dividends have historically accounted for 20% of the returns investors in the S&P 500 stocks have earned.

    All this being said, the higher the dividend yield on the index stocks, the less valuable EIFAs are to investors.

    As always, Keith, may you enjoy fair winds and following seas.

    Cheers, Will

    ps: Makena will be 1 year old at the end of this month, and please tell Lynn that I send my best.

Notice: Undefined variable: user_ID in /home/thegloba/theglobaladventure/wp-content/themes/tga/comments.php on line 73

Name (required)

Email (required)