« NASD Warns Against Borrowing Money To Invest | Main | Top Ten Investment Scams »

February 14, 2005

Equity Index Annuities: Beware

I did a series of talks last week and in one of them, someone asked me about equity indexed annuities. He wanted to know if equity index annuities didn't achieve the same objectives as my cash flow method. Unfortunately, being in the Q&A section of a talk like that, I didn't have enough time to talk about all the problems with EIA's.

 

Robert Powell, of MarketWatch outlines the issues very well in an article this week titled, A Ball of Confusion.

 

"Sales are booming because people have been terrified of the volatility in the stock market," says John Olsen, head of the Olsen Financial Group in Kirkwood, Miss.

 

Yet EIAs are among the least understood and most oversold products in America today, Olsen says. And they bear an often overlooked risk -- they're dependent on the financial strength of the insurance company offering them.

 

"A lot of sales are not proper," Olsen says. "A lot of agents sell EIAs as an alternative to stocks or to bonds or CDs and that's not appropriate.

 

"It's a fixed annuity and annuities are not investments. They are risk-management products. They are not alternatives to bonds because they don't act the same. They are horribly complicated."

 

There are some things you need to understand about equity indexed annuities. When you read the fine print, they are not all they are cracked up to be.

 

• The minimum guaranteed rate: That's the rate of interest the insurer guarantees to give you, the contract holder. The minimum rate currently ranges between 1.5 percent and 3 percent, typically on 90 percent of the initial premium deposit. But Shah says many insurers are lowering the base upon which the guarantee applies as a way to improve profitability and reduce some of the risk that comes with selling EIAs in a low-interest-rate world.

• Participation rate: This is the rate at which you, as EIA owner, share in the upside of the equity index being tracked, typically the Standard & Poor's 500, but increasingly other indices as well. Typically, the rate (say 55 percent of the S&P 500 minus the dividend) is set when the EIA is issued and guaranteed for one year. The participation rate will depend on interest rates and the cost of call options.

• Spread deduction: This is the fee charged by insurers for their expenses. Usually, it's deducted from the percentage increase in the equity index being tracked.

• Return cap: This is the maximum rate that can be credited to an EIA owner's account, regardless of the actual market returns. Typically, that cap is set low such that an EIA owner can expect to earn the minimum guaranteed rate, say 2 percent currently, plus another 2 percent when the stock market rises -- 4 percent overall.

• Index-crediting methods: Insurers use various formulas to calculate the equity index's return for your EIA. The most common method is the annual reset-averaging index, but there are others.

 

The gist of it is, that although these things are advertised as getting all the upside potential as the stock market rises, the truth is that you get very little of it. In the end, most of these equity index annuties will end up paying somewhere around 1% - 2% as a guarantee and 4% - 5% when the market is going up.

 

If you want low risk and you are satisfied with those sorts of returns, high grade bonds will achieve the same thing more effectively.

 

SOURCE:

 

1. Robert Powell, "A ball of confusion. Beware equity index annuities promising returns sans risk." CBS Marketwatch.com 10 February 2005 http://cbs.marketwatch.com

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

 

Posted by Kim Snider on February 14, 2005 | Permalink

Comments

The comments to this entry are closed.