My friend, Allan Roth, posted an article today about an equity indexed annuity that he came across (you can read Allan’s piece here). It’s an interesting piece that details certain tricks that companies use in order to lure people into their products.

I want to focus on his trick #2 – “average annual” return. According to Roth:

If you actually possess the attention span to slog through the 373 page disclosure document, you would clearly see on page 189 that the term â€œaverage annual returnâ€ is defined as 1/12 of the first month plus 1/12 of the second month, etc. This translates to getting an expected tad over half the total annual return. Depending on the timing of the market increase, this could be either more or less than half. In this example, it yields about 54% of the total increase of the index.

I asked Allan for clarification on exactly how this works and this is what he said:

“Youâ€™d have to use 1/12 of the YTD returns. The 12th month would count the full yearâ€™s return but it would only weight 1/12 of the amount.”

Allan did not provide me with the name of this particular annuity so I don’t know all the details. He did, however, tell me that this particular EIA will not allow the account to have a negative return over the year. It’s important to note that this is over the year and not on a month-to-month basis.

In order to see how this would work in the real world, I used the 2009 monthly returns for the S&P 500 Index (NOTE: These are index returns and NOT total returns, which would include dividends). Here is what I found:

In case it’s not clear, the YTD column is what’s used to calculate how the account is credited. Each of the months are credited 1/12th of whatever the YTD return is on the index. Then, those amounts are summed to get the return for the year. So, for 2009, while the index returned 23.45% (not including dividends), this annuity was credited with a 5.01% return (BEFORE FEES!). If you take off the 2% for fees, the return is down to around 3.01%.

Who in the world would go for such a product? Clearly this particular product favors the insurance company. They get the dividends and the 2% management expense. If the insurance company invests in the underlying index, they get the spread in returns (23.45 – 5.01).

I would avoid these products. They are complicated and very different so that it’s very hard to make an apples-to-apples comparison. I would stick to a fixed immediate annuity or possibly a very low cost variable annuity. If you are enticed by a an equity-index sales pitch, do yourself a favor and get a second opinion BEFORE you sign any documents.

12 responses to Another Equity Indexed Annuity I Would Avoid

1. I agree that EIAs are too hard for most people (maybe all people) to understand. They have sleazy salesmen behind some of them, and the marketing materials themselves are misleading.

But stripping all that away, I think it’s more fair to compare them to other risk free investments than it is to compare to stock market returns. The return of an EIA can’t go negative, putting it in line with Treasury bonds and money market accounts. Put in that league, 3% isn’t so bad. Of course, it’s fair to say that it’s insurance companies’ own fault for making the stock market connection…

2. Pop wrote:

“itâ€™s fair to say that itâ€™s insurance companiesâ€™ own fault for making the stock market connectionâ€¦”

EXACTLY! The insurance companies create these products designed to get “stock market performace without the risk.” Then, when you compare them to stock market returns, they cry that it’s not fair and that these products should be compared to bonds or some other fixed investment.

The example above shows that the upside of this particular annuity is very limited. Therefore, it really isn’t any better than a laddered CD or other fixed income investment except that the agent gets paid generously for selling such a product.

3. Amazing investigation — wow.

4. Great post Jeffrey. You made my example in my blog look pretty generous compared to your calculation of the actual return during the 2009 bull market.

It’s great to know one of the good guys in investing!

Allan

5. Thanks, Allan. Keep up the good work. I like the investigative stuff.

6. You’re our very own Geraldo Rivera, without the funky moustache!

• Haha. Actually, I think that title should be reserved for Allan. All I did was take what he wrote a little farther by looking at last year’s returns. If it has something to do with a spreadsheet, I’ll like it…lol.

7. Annuities are not investment vehicles. If it were up to me, variable annuities would be banned altogether.

Fixed annuities and life insurance serve a purpose.

8. Great post. JLP is right that insurance companies and their salesmen push these as all gain, no pain. Get stock returns with no downside.

Whenever I hear someone tell me they are going to invest in an insurance product for the return, I tell them to look at how the insurance company invests the assets then replicate it. For instance, those who are crazy enough to purchase a permanent life policy for the stable returns should just create a portfolio with 80-90% bonds like the insurance company does.

With an EIA, the insurance company uses a 90/10 strategy with index options. I know people hate options, but it isn’t as complex as one thinks. If you have a \$1Million portfolio, then you take approximately 10% or \$100,000 and buy option contracts on the S&P 500 or other index. With the contracts you control \$1 Million of stock with the 10% premium. With the other 90% of your million dollars, you invest in treasuries, CDs or other income bearing investment. The interest earned on the fixed income offsets the cost of the option contracts. So if you get 4% in interest, the worst your return would be is down 6% (10% of option cost minus 4% interest). However, if the market goes up, you get the full upside of the market’s return whereas the EIA caps your upside as JLP shows. Plus, this strategy allows you to avoid the 2% per year admin costs, and you control your money, rather than being limited to taking 10% out per year (and having surrender charges for the first 10 years or so).

This may seem confusing, and I would be willing to explain further if you like. It does show that replicating the insurance companies actions provides a higher return with the same lower risk. Granted, you could be subject to a 6% loss with this strategy, but you get a much higher upside so you come out ahead over the longer term.

9. The equity indexed annuities sometimes gets a bad rap because of the fees involved… one client who bought one indexed annuity at the best possible time (about six months before the market completely imploded) she saved about \$100,000 in losses if it had been where it was before we moved it to the indexed annuity.

Her stock portfolio in contrast lost more than \$250,000 in market value!!! She was not complaining when she had to pay the higher fee!

10. @#10 Jack Thomas:
Oh, please give me a break. You gave your best single example of one client in an unusual time period. That is about as self-serving as you can get, Mr. Annuity Insurance Salesman. Your client might not be complaining this year, but she will if someone honestly runs the numbers for her. [I was invested in stocks during the down-turn. I’m now better off, without your high fees.]

How about giving us examples of your _typical_ clients, from whom you took commissions of 5% of their total investments and cost them 2/3 of their investment gains over the next 5 to 10 years as compared with a low cost stock index fund? That is how annuity insurance contracts work. You get the commissions, your company invests the money in stocks, keeps all of the dividends and most of the appreciation, and your clients get peanuts. Of course in a down year your clients are “saved” from losses, but over the long term they are still behind their peers. Your clients lose a lot of money in the long term compared with stocks; this is just not apparent to them immediately. When taking inflation into account over 5-10-15 years, I would guess that your annuities actually lose purchasing power compared with other investments. Don’t pat yourself on the back too hard. People who read this blog can actually do math (so we’re not your target audience).

11. You just don’t understand.
The insurance company doesn’t invest in the index–they buy options–they don’t rake in the difference. And there is no 2% management fee. Look at any insurance company’s investment portfolio; it will be comprised mostly of investment grade bonds–little if any stocks, mutual funds, etc. Most of the money goes to bonds to secure the guarantees. To compare an index annuity to a stock investment is wrong–compare it to a CD or other fixed investment where there is no risk of loss.