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.