Equity Indexed Annuities to Avoid- Always!

Originally, Equity Indexed Annuities, first introduced in 1996, were based on a simple concept: provide an annuity with a guaranteed minimum annual return (initially 3.0%) that has the potential to earn a higher annual return based on the performance of the S&P 500 index.  For those investors and savers who wanted a potentially greater return with no risk of losing their principal, it was a very attractive alternative to bank CDs and savings accounts (as well as fixed annuities).  As additional insurance companies entered this market over the past eight years, however, many of the newer generation of Equity Indexed Annuities have become decidedly more complex and in some cases a very poor investment.

The purpose of this special report is to help the reader identify and understand those features and complexities that should be avoided - always - when considering any Equity Indexed Annuity (EIA).  If you have recently purchased an EIA you may still have time to use the information in this special report to make an informed decision as to whether you should keep that annuity contract, or return it to the insurance company for a full refund.  Here in Colorado, state insurance laws mandate that every annuity must offer at least a 10 day free look period - but if you acquired the new annuity as a result of surrendering another annuity, state law mandates that you be given up to 30 days to reconsider your decision.      

To simplify your review, I am going to divide this report into the ten key points I believe are the most critical elements to consider when evaluating any annuity contract.  Before I do that, I must make the following, very important statement:

The purpose of this report is not to condemn all annuities or all insurance companies.  Annuities have played a vital role in securing the retirement of millions of Americans for many decades and I believe they will continue to do so for many more decades.  Here at Hallmark we recommend annuities to many of our clients, but we carefully select which annuities to recommend and give each client the benefit of full disclosure of all fees, surrender penalties and benefit riders associated with each annuity contract.  You deserve nothing less!

 Here are the 10 Key Points to consider in every annuity contract:

1. Surrender Charges

The average number of years a good annuity contract assesses a surrender charge is from 3 to 7 – and those surrender charges usually average no more than 8.0% to 9.0% in the first contract year.  Unfortunately, many of the companies issuing what I consider to be poor Equity Indexed Annuities today are assessing surrender penalties for as many as 15 years - and they are charging as much as 25% in the first contract year!  That is outrageous, especially so in contracts where the 25% penalty lasts for the first five years, before gradually tapering off over the remaining ten years.

RULE:  Never accept an annuity contract that assesses surrender charges in excess of 9%, or last more than the first 7 or 8 years of the contract.

2.  Penalty-free Withdrawals

Most annuity contracts will afford you the right to withdraw a portion of your invested premium penalty-free each year.  However, there can be significant differences in the amount you are allowed to withdraw without penalty. Almost all annuity contracts allow you to withdraw up to 10% of your premium penalty-free during each contract year, following the first year.  Any annuity that does not offer penalty-free withdrawals should be avoided – after all, it’s your money and you should be entitled to reasonable penalty-free withdrawals.  Here are the typical alternatives – listed in order of most to least favorable:

a)     the greater of 100% of contract earnings or 10% of premiums paid – cumulative

b)     10% of contract value – cumulative

c)      10% of contract value – each year but not cumulative

d)     10% of premium only – each year but not cumulative

e)     No penalty-free withdrawals allowed

RULE:  Penalty-free withdrawals are important – avoid annuities that don’t offer any penalty-free withdrawals or limit you to only 10% of your premium each year.

3.  Bonuses

The biggest hook some insurance companies use to attract your attention is the first year bonus.  Such bonuses can range anywhere from 7% to 12% and in today’s interest rate environment that can be very attractive – and sometimes, very deceptive.  The vast majority of such bonuses are not yours to keep – unless you annuitize the annuity contract at the end of the 10^th year or sooner.  In other words, if you ever want to simply take the value of the annuity contract and walk away, the bonus vanishes!  Remember, annuitizing a contract amounts to exchanging your contract value for a guaranteed lifetime income – you no longer have access to your cash value in the contract!

RULE:  Read the fine print when it comes to up-front bonuses – they are often not what they appear to be.  And remember: big bonuses are often associated with less competitive annuity contracts – they are used as bait to draw you in!

4.  Monthly Index Averaging

In some annuities, the average of an index’s value is used rather than the actual value of the index on a specific date.  In other words, while the S&P 500 index may be up 21% in a given year, the actual gain in the annuity is based on averaging the monthly gains and losses throughout the year.  This is seldom in your favor!  Historically, an index like the S&P 500 will move in spurts throughout the year, with the majority of the yearly gain occurring in two or three months.  When you average those really good months with the other nine or ten months, the monthly average is often far less – and the difference can be significant!

RULE:  Avoid annuities that calculate the annual index performance by averaging the monthly gains and losses!

5.  Monthly Caps

In order to limit their exposure when stock indexes enjoy a banner year, most insurance companies place a cap on the amount of index earnings you can be credited with in any given year.  This is a prudent practice and I have no argument with it – as long as the cap is placed on the total annual gain, not on monthly performance!  Several companies are now promoting a 3.0% monthly cap and I find this to be very misleading.  Why?  Because most people automatically do a calculation in their heads, multiply the monthly cap by 12, and come to the conclusion that they have a 36% annual cap on their EIA contract.  In reality, in order to earn up to 36% in any given year, the index would have to earn at least 3.0% every month and in the past 20 years that has never happened in the S&P 500 Index.  In several of those years a 3.0% monthly cap produced an end result that was less than 50% of the actual year-end performance of the index.

RULE:  Avoid annuity contracts that impose a monthly cap on the performance of any index.  Better yet, look for annuities that do not have any cap on index performance!    

6.  Using Fixed Accounts

Over the past few months we have seen a number of EIA contracts where the agent who sold the annuity recommended putting all or a significant portion of the total premium invested into a fixed account paying 3.25%.  The rationale for this recommendation escapes me.  The purpose of investing in an “Equity Indexed” annuity is to participate in the equity markets during good years, while avoiding any losses during bad years.  If that is indeed your objective, why put your principal in a fixed account, especially during 2003 when the S&P 500 Index was up over 27%?  If the objective is to participate in the equity markets, then by all means, participate – which means investing your principal in those accounts that are linked to one of the numerous equity indexes.

RULE:  If you really want a fixed rate of return, buy a Fixed Annuity – they’re cheaper and have less onerous surrender penalties!

7.  Annuitization

There are several major insurance companies that require annuitization in order to receive credit for earnings tied to one of the equity index options.  In other words, these annuity contracts track two separate earnings accounts; one based on the guaranteed minimum annual earnings (currently ranging from a low of just 1.5% on 87.5% of premiums paid) and the other based on the earnings of the particular equity index option (or combination of equity index options) chosen.  In order to receive the accumulated value of the equity index options chosen, however, you must annuitize the contract after a minimum number of years (usually 10 years).

Again, as stated earlier, if you annuitize the contract you no longer have access to the cash value – you have exchanged that cash value for a guaranteed lifetime income (which in most cases is a fixed monthly income with no annual inflation adjustments).  For people in their eighties, the guaranteed monthly income afforded by annuitization may be a good thing, but for younger retirees it could be a financial catastrophe.  

RULE:  Avoid EIA contracts that require annuitization in order to receive the earnings generated in the equity index linked options.  It is your money – you shouldn’t have to forfeit the right to have access to it in the future!    

8.  Point-to-point contracts

Most of the original EIA contracts calculated the equity indexed linked options on a point-to-point basis.  For example, if the contract was issued for an initial 7 year term, the starting point was based on the value of the equity index (S&P 500 Index for example) on the date the contract was issued.  The ending point was the value of that same index at the end of the contract term (7^th year).  If the value of the equity index was higher at the end of the term, the annuity was credited with the difference (subject to any caps or participation restrictions), but if the value of the equity index was lower, the annuity contract would earn nothing more than the minimum guaranteed return.

We have seen point-to-point EIA contracts that were purchased in 1999 when the S&P 500 Index was at 1490 and as of December 21, 2004 (5 years later) that same index is only at 1194.  Unless there is a 20% increase in that index over the remaining two years, the owners of such contracts will receive a minimal return on their initial investment.

RULE:  Avoid point-to-point EIA contracts – you could have your money tied up for a long period of time (7 to 10 years or more) and still end up with a minimal return!  

9.  Annual Reset contracts

Fortunately, most insurance companies have come up with a better alternative to the point-to-point structure – the Annual Reset contract.  Under this structure, the selected index is stated in the contract as of the date of issue and the gains (if any) are measured on a year by year basis.  In other words, using the example above, if the index on the issue date of the annuity was 1490 and one year later it had dropped to 1200, there would be no index earnings for that first year.  However, in the second year of the contract the starting point for measuring the index is adjusted to the 1200 level and any gains realized during that second year are locked in for the life of the annuity.  Even if the index never returns to the 1490 starting point at the end of the term (7 or 10 years) it is quite possible that there could have been some significant gains locked in during that term.

Some companies measure the annual reset term according to the anniversary date of the annuity contract (for example: July 14^th through July 13^th  each year) while others will prorate the first year and then convert to a calendar year basis as of the first of January.  There is little difference between the two structures, so either is acceptable.

RULE:  If you are set on purchasing an Equity Indexed Annuity, make sure the index options are structured on an Annual Reset format.  That way you are assured of locking in your gains (if any) on a year by year basis!

10.  Market Value Adjustments 

Most EIA contracts offer a guaranteed fixed account option and while I don’t recommend using this option except on rare occasions, there may be a time where you could benefit by moving your accumulated value into such an account on a short-term basis.  However, while most companies will guarantee the return in the fixed account option for a one, three or five year term (sometimes longer) they also reserve the right to adjust that “guaranteed” return (called a Market Value Adjustment or MVA) if you choose to transfer funds out of the fixed account before the end of the guarantee term.  This allows the company to recuperate any potential losses from having to surrender a bond early in order to meet your redemption request. – which, if you think about it, is just an excuse for the company to reduce your earnings given the amount of cash reserves these companies usually have on hand at any point in time.

If you are transferring out of a fixed account option, and surrendering more than the annual penalty-free withdrawal amount at the same time, you will likely be hit with a double penalty: both the Market Value Adjustment and a surrender penalty. 

RULE:  Avoid Equity Indexed Annuities that reserve the right to charge a Market Value Adjustment on early withdrawals or transfers from the fixed account option!

Conclusion

Not all Equity Indexed Annuities are poor investments – but some are!  The important thing is to have enough information to enable you to make an informed decision so you can choose the annuity contract that best meets your needs.  That annuity may be an Equity Indexed Annuity – or it may not.  In my professional opinion, the newest version of Variable Annuities, especially those that include Guaranteed Minimum Withdrawal Benefit riders, offer the same assurance of protecting your principal but with far better alternatives to participate in the growth potential of the equity markets.

If you are determined to purchase an Equity Indexed Annuity, remember to consider the ten key points discussed herein.  In summary, they are:

1.  Never accept an annuity contract that assesses surrender charges for more than the first 7 or 8 years of the contract.

2.  Penalty-free withdrawals are important – avoid annuities that don’t offer any penalty-free withdrawals or limit you to only 10% of your premium each year.

3.  Read the fine print when it comes to up-front bonuses – they are often not what they appear to be.  And remember: big bonuses are often associated with less competitive annuity contracts – they are used as bait to draw you in!

4.  Avoid annuities that calculate the annual index performance by averaging the monthly gains and losses!

5.  Avoid annuity contracts that impose a monthly cap on the performance of any index.  Better yet, look for annuities that do not have any cap on index performance!    

6.  If you really want a fixed rate of return, buy a Fixed Annuity – they’re cheaper and have less onerous surrender penalties!

7.  Avoid EIA contracts that require annuitization in order to receive the earnings generated in the equity index linked options.  It is your money – why should you forfeit the right to have access to it in the future!    

8.  Avoid point-to-point EIA contracts – you could have your money tied up for a long period of time (7 to 10 years or more) and still end up with a minimal return! 

9.  If you are set on purchasing an Equity Indexed Annuity, make sure the index options are structured on an Annual Reset format.  That way you are assured of locking in your gains (if any) on a year by year basis!

10.  Avoid Equity Indexed Annuities that reserve the right to charge a Market Value Adjustment on early withdrawals or transfers from the fixed account option!

Disclaimer

This report is not intended to answer every possible question that may arise when considering the purchase of an Equity Indexed Annuity.  Rather, its intent is to enable the reader to ask the right questions and make certain they receive the necessary answers to enable them to make an informed decision in that purchase.  The opinions expressed herein are strictly those of the author and I recognize that other professionals in the annuity industry may disagree with me.  In the end, if this report helps you to ask the right questions and make certain you are given full disclosure prior to purchasing any annuity contract, the report will have served its purpose.

Finally – if you have immediate questions after reviewing this report, you may contact your insurance or annuity professional, or you may call me at 303-756-8900.

Respectfully submitted:

Don Hartmann, CLU, ChFC, CSA