Beware the Siren Call
Investors can buy into a contract offering a minimum return with the potential to capture the upside of increases in the stock market while avoiding portfolio value declines if - and when - the market goes down.
This blend of promises can be found in 'equity-indexed annuities" or EIAs offered by insurance companies.
And these offerings have become popular given the steep declines in the stock market. According to a report in the WSJ (9/02/09), sales of EIAs during the first half of 2009 rose 20% compared to a year ago to $15.2 billion.
As compelling as these products may sound, they are anything but simple. There are many complicated moving parts to each EIA contract. So buyer beware!
Think of investing as finding the route to your destination (a goal) and matching that with the appropriate mode of transportation (or investment vehicle) to get you there. You may be traveling from Boston to New York and can choose highways or back roads. You can choose hi-speed rail, a car, a bus, a bike or even a plane. You can drive or fly yourself or hire someone else to drive. All will get you to where you want to go but it's a question of what kind of comfort level you want on the ride, how much time you have to get there and at what cost - in fees or simply mental health.
For those who may not have the stomach for the gyrations of the stock market but are looking to be more venturesome, the EIA may be a suitable compromise. It's sort of like someone hiring a driver for the trip but traveling on main roads while avoiding highways.
First, understand that an annuity is offered by an insurance company and backed by the credit-worthiness and deep pockets of the insurer. There is no FDIC backing. This is not a bank product (although you may find them sold by brokers with desks in banks).
Next, understand that an index can be any benchmark for any asset class or market. The most common benchmarks include the Dow Jones Industrial Average (DJIA), the S&P 500 and NASDAQ in the US. Overseas, indexes include the NIKKEI in Japan for instance.
An equity-indexed annuity (EIA) ties the amount that will be credited to an investor's account to the performance of a particular index.
But don't expect to receive a one-for-one increase in your account value based on the index's increase. Instead, these contracts include a "participation rate" that sets a percentage of the index gain that is used.
The index-based interest credit may be further limited by "caps" that set a maximum amount of gain.
For anyone who has ever had an Adjustable Rate Mortgage, the process is very similar to how loan rates are recalculated.
Calculating the interest credit is further complicated by the method of measuring the change in the index value. For instance, the insurer can determine the index change based on the "Annual Reset" - the difference between the index value at the beginning and end of each contract annual anniversary date. Or a "point-to-point" method may be chosen that compares the index value at the beginning date with some future date like the fifth anniversary. Or the insurer will use "index averaging" taking multiple index returns and averaging them.
By the way, the index value won't include changes resulting from dividends. While total return on the S&P 500 averaged 9.5% between 1969 and 2008, more than one-third of the return was attributed to dividends. So these EIA market participation formulas will be calculated on a lower base when dividends are not considered part of the index return.
Typically but not always, there is a minimum amount of interest that is credited. But be aware that this minimum interest credit may not apply to 100% of the contract value. It may apply an interest rate of 3% to only 90% of the value. It may apply 1.5% interest to 85% of the total value. It all depends on the terms of the contract.
EIA contracts have dual values: the one based on the index value, participation rate and cap; the other based on the minimum interest credit. And if you get out of the contract before the full term, you may be forfeiting the index-based account value. The insurer would then pay out the amount based on the minimum guaranteed portion which may be lower than what you expected compared to the index formula.
And how many football fans would be happy if their favorite team was on the 1-yard line and the referees moved the goal post? Well, most EIA contracts reserve the right to unilaterally change terms reducing the participation rate or using stiffer lower, caps for example.
And most contracts have very steep surrender charges that can start at 10% to 15% of the contract value in the first year and declining from there for up to 10 years.
And be aware of the financial incentives that are part of these contracts. Some EIAs offer "bonuses" to investors - an extra 5% or 10% added to the initial deposit. But there is no free lunch. In exchange for such a bonus, the insurer will likely increase the surrender penalty. So as much as the bonus is an incentive to open the contract, the penalty is an incentive to not move the money out.
Follow the money, too. Many EIAs pay out commissions to brokers between 6% and 10% and sometimes more. An investor should be aware that there may be an incentive by a salesperson to offer this as a catch-all solution whether or not it fits the investor's particular situation.
The advantages to an EIA include the opportunity to participate in the upside of a market index as an alternative to investing directly through mutual funds for instance. When an investor opens up an annual statement, there may be less apparent volatility because the account balances aren't fluctuating wildly. So this may help a conservative investor dip a toe in the market and sleep better. And like most annuity products, investors have free access to a portion of their money without surrender charge (usually 10%). And like any other insurance product, it provides a guaranteed death benefit. Like other annuities, it offers an income stream that you cannot outlive.
The average return on such EIA contracts has been reported to be in the 5%-6% range. Given the complexities of these contracts and the average returns, it may be a costly way to limit your market exposure but it may make sense for those looking for a principal-protected CD alternative for the cash portion of their portfolios as well as a source of income to supplement retirement.