What You Don’t Know About Equity Indexed Annuities Could Hurt You
In the past couple of decades, annuities have become more popular with financial advisors and retirees for retirement planning. In many cases, annuities can be a valued part of a well-diversified portfolio. However, there are also many characteristics of annuities that can make them undesirable or even hurtful in retirement planning. Annuities have evolved from simple pension replacement plans and CD alternative types of investments to include complicated investment vehicles that many advisors claim to deliver gains regardless of market performance. Often, it’s the claim of market returns without risk of loss that draws the prospective investor in for a closer look.
There are many types of annuities, each with their advantages and disadvantages. The pension replacement or Single Premium Immediate Annuity (SPIA) and CD Type or Fixed Annuities still exist, as well as what’s called a variable annuity. The annuity that has seen the most growth over the past 20 years is the Equity Indexed Annuity, or EIA. According to LIMRA, “In 2012, indexed annuity sales hit a record high of $33.9 billion.”
It’s interesting that the EIA consistently sees record growth compared the other annuities because they are also arguably the most complex and least understood annuity of them all. In fact, it’s the complexity of the EIA prompted The Financial Industry Regulator Authority (FINRA) to issue an Investor Alert on EIAs. The Alert states, “EIAs are anything but easy to understand. One of the most confusing features of an EIA is the method used to calculate the gain in the index to which the annuity is linked.”
So, are EIAs growing in popularity because they are a better investment compared to the alternatives that are available in retirement? Is the average investor becoming more financially savvy and able to understand complex investments? Both are unlikely and, in my experience, not the case. The primary reason EIA’s sales continue to grow year after year is marketing. Insurance companies and insurance sales people have become increasingly effective in marketing the EIA as a retirement safety and income solution. These products are often marketed through seminars, radio shows, direct mail and newspaper advertising. Insurance companies and sales people are getting more effective at reaching a specific demographic that is brimming with new prospects considering what to do with their 401ks, IRAs, etc.
What makes the EIA so complicated? The most complicated part of indexed annuities is how they calculate your real return each year. To further complicate things, EIAs offer riders that confuse investors even more. Your real or actual return on an Equity Indexed Annuity is calculated differently, depending on which contract you have. You will typically participate in an index. Some examples would be the S&P 500 index or the NASDAQ 100 Index. The question becomes how much of the gain in the index to in which you participate in. Many times, an investor is left with the impression they will participate in all of the gains of the index. Unfortunately, that isn’t the case. Insurance companies that offer EIAs utilize a variety of methods to limit participation in index gains. These methods include participation rates, caps, spreads, margins and asset fees.
It’s the complexity of how the returns are calculated that seems to keep investors in the dark as to if an EIA is right for them. Many investors simply throw in the towel on trying to understand them and rely on the sales person for an accurate representation of how the investment will perform.
We are asked “what should someone expect to earn in an Equity Indexed Annuity“. There are many studies out there that have compared various EIA performances. A recent study by the Advantage Compendium found that the average annualized indexed annuity returns for the period 2007 to 2012 averaged 3.27%. Ask yourself if you feel an average of 3.27% per year on an account is a satisfactory return. If the answer is yes, then you may consider EIAs, but did you compare that rate of return to other investments over the same period of time? For example, over that same period of time, The Vanguard Total Bond Market Index Fund averaged 6.5% per year while being liquid, whereas the annuity may require a 10-year contract and only allow 10% liquidity per year.
A lot of times, the devil is in the details. EIAs can be a valuable part of a portfolio if you understand exactly what you are getting into. Many people believe they are going to average 6-8% per year growth in their principle because that’s the impression they were left with after speaking to a sales person. There isn’t any data to support that type of real return on EIAs and they simply aren’t designed to perform that way. With many EIAs requiring a 10-year contract or more, would you be willing to commit to a 10-year contract with an average return of 3.27% per year? Do you think CD rates could be higher than 3.27% in the next 10 years? If so, you would have to pay a penalty to get your money out of the annuity and into CDs. Many investors will miss out on future investment opportunities because they have committed too much of their investible assets to long-term annuity contracts.
EIAs are promoted as risk-free investments when in fact the only risk they protect you from is market risk. The risks associated with the EIA are liquidity risk because you are paying a severe penalty if you take out more than 10%. You also have inflationary risk; if the EIA is averaging 3.27% and the average inflation rate is 3.22%, you have a problem. One of the biggest concerns we have is the number of retirees in their 50s and 60s is that are committing large amounts to EIAs. If the EIAs aren’t doing a good job of keeping up with inflation and you are likely to live 20 to 30 years, the EIA may have a negative impact on your retirement.
Although EIAs are popular with many advisors and insurance agents, they aren’t always going to be the answer to all of your retirement financial concerns. As with any investment, make sure you know all of the advantages and disadvantages before you invest. If you currently have or are considering an EIA, make sure you have a good understanding of them. Last but not least, trust your instincts. If it sounds too good to be true, it almost always is.
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Interesting that you use a bond fund to compare the EIA 2007 to 2012 returns… The Annualized S&P 500 Return (Dividends Reinvested) was 2.153% for that period with A LOT of volitility.
Thanks for the reply. Not sure I’m clear on your comparison but I think you are comparing the S&P 500′s annualized return over that period with that of what one may have earned inside of an Equity/Fixed/Hybrid Indexed Annuity. The intent of comparing the bond fund was to compare performance of Indexed Annuities to another investment that some investors may consider an alternative to stocks or mutual funds. Many times Indexed Annuities are positioned as an alternative to participating in the stock market. All investments have advantages and disadvantages. The article isn’t intended to make a case for or against Indexed Annuities. The only intent is to provide information to potential investors so that they can make an informed decision. I am sorry to say that I have met with far too many investors who own an indexed annuity, and their only understanding of it is that they participate in market gains and can’t lose money. While that is a feature and a good one it only tells part of the story.
I have been an advisor for 30 years and have substantial experience and knowledge in the financial world. This piece is so one sided, it is very annoying. By the way, the term, “EIA”, went away many years ago, because of “regulatory sanctions”.
You sound like a version of Suze Orman! You only tell part of the story, the one side you want to promote. What is your agenda anyway? And I agree with DAVE, you use ’07- ’12, to skew the numbers for bond funds. How about the using bond funds from ’12-’14.
Anyone with savy, could see through your smoke in seconds!
The intent was not to annoy anyone. I for one don’t find facts one sided or annoying but to each his own. As far as how we should be referring to Indexed Annuities, they are commonly referred to as Equity Indexed but if you prefer to use Fixed Indexed or Hybrid they all mean essentially the same thing.
I take it your NOT a Suze Orman fan.. Can’t say I’m familiar enough with her to comment but I am neither for or against Indexed Annuities and as the article suggests I only have concern for how they have been promoted to some individuals. Articles like mine will hopefully empower potential investors to ask the right questions prior to making a potentially long term commitment. Knowledge is power right?
To answer your question, my agenda is to educate the average investor so that they can make informed decisions. Indexed annuities happened to the the topic of the week. As savvy as a 30 year professional should be, please feel free to clear the smoke and point out the inaccuracies in the article.
Thank you for commenting.
Enjoyed reading this article. Personally, I did not take this article as “bashing” FIA’s. It was more objective and educational. Annuities can be quite complex so being clear on the details are crucial. One of the concerns I see is finding the right annuity that will keep up with inflation over time, especially since todays CPI numbers do not include, food & energy. There is a place for FIA in a retirement portfolio but its not the answer for everything.
Keep up the good work.
Part of my retirement is invested in a Guardian annuity. I started this annuity about 4 yrs ago. I am “guaranteed” a 7% return on the anniversary date or the market appreciation. I’m not sure how I lose unless Guardian goes out of business. I’d like to talk early next week. Thanks Bob
Thank you for visiting my blog. With regards to your annuity I would be happy to speak with you. While some annuities have riders that guarantee an increase in the income account this is not the same thing as a guarantee of a 7% return. A 7% return implies that your principle invested is guaranteed to grow by 7% per year. In addition you mentioned you were guaranteed a 7% return or market appreciation. I assume your understanding is that you would take whichever one is higher. It’s very important to understand the difference between income account values and actual account values. Unfortunately the difference isn’t always detailed by the salesperson that gets the commission if they can convince you to buy. I am sorry to say I see people in your situation every week. What I can tell you is that there isn’t an annuity today and there wasn’t one 4 years ago that guarantees a 7% increase in the account value or market returns whichever is higher. The good news is you’re finding out about it now as opposed to later and there are several ways we may be able to help.