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Fixed index annuities: Perfect product or a ripoff?

Fixed index annuities: Perfect product or a ripoff? -
Jeremy Burger

By Jeremy Burger, Chief Executive Officer CFA®, CFP®
Published On 03/23/2009

Much of the financial industry is hurting these days, and you can bet that Wall Street is working overtime to hook investors in one way or another. Insurance companies are promoting a product that looks (at least to them) like a winner, especially during tough times.

You can barely pick up a financial publication lately without seeing ads for fixed indexed annuities, often called equity index annuities. The ads promise a lot. But does the product deliver the goods?

Many investors seem to think so. An estimated $26.7 billion went into equity index annuities in 2008, according to’s Advantage Index Sales & Market Report. I think there are three main reasons. First, they offer downside capital protection at a time when nothing seems to be working for investors. Second, they seem to offer market-like returns. Third, sales representatives are being paid high commissions to push them.

If you haven’t seen or heard the pitches for equity index annuities, you probably will before long. Wall Street has identified this as a profitable product – profitable, that is, for Wall Street.

The Claims

Here’s what you may be told: With a fixed indexed annuity you get a guaranteed minimum rate of return or the return based on an underlying stock index, whichever is higher. What could be nicer? Upside potential and no downside risk. Wall Street would like you to believe that finally somebody has devised a product that’s on your side all the way.

Technically, the claims are accurate. If you wait long enough (think about up to 16 years), you can get all your money back plus some return. However …….

The Reality

There’s an old – and very good – rule of thumb that recommends against putting your money into anything you don’t understand. It’s hard to do that with equity index annuities, which are very complex products. To fully understand them, a doctorate degree in math could be helpful. I recently talked to an investor who was disillusioned after purchasing one of these. If he had understood the details, I don’t think he would have done so.

In December 2008, Forbes magazine told the story of an investor who purchased five equity index annuities for $1.4 million from a sales agent who billed himself as a senior financial advisor. The investor said the agent told him the annuities had a guaranteed minimum 3 percent annual return and said the policies (because annuities are actually insurance policies), which track the Standard & Poor’s 500 Index, had earned 12 percent annually.

The investor described these claims as “music to my ears.”

The reality turned out to be something else. He later learned he would receive only part of any gains of the index, that he would be subject to stiff penalties for withdrawing his money and that the 3 percent guarantee applied to only part of what he had invested, not all of it. Eventually, he also learned that the insurance company had paid the agent a substantial commission, which he estimated at $125,000, to sell him those five policies.

Pesky Details

If you look “under the hood” of these policies, you will find some specific provisions that are likely to cool your enthusiasm. Here’s a sample:

Stock Index: Your return will be based on an external index; it might be the Standard & Poor’s 500 Index or one of any number of other possibilities. But you may not get what you expect. The annuity contract, which requires your signature saying you understand it, may say that the appreciation of the index will be calculated after excluding dividends. Historically, dividends have made up much of the appreciation of stock indexes. Too bad you won’t get them.

Some policies figure your gain by measuring the value of the index on two dates, most likely two successive anniversary dates of your policy. If the index was at 1,000 on the day the policy went into effect and at 1,120 one year later, this method would show a 12 percent gain. A mutual fund tracking the same index would show a higher gain, because the fund owned stocks that paid dividends.

Let’s use some numbers to see how much difference it might make. In positive-return years for the S&P 500 Index going back for the past 20 years, the dividend component made up anywhere from 6.7 percent to 41.4 percent of the total return of the index. In positive years from 2000 through 2008, dividends made up 22.9 percent of the return, on average. In 2004, the index with dividends gained 10.9 percent; without dividends it rose only 9 percent.

Crediting Method: This is where you can discover how a small difference in words can make a big difference in dollars. In perhaps the most complex part of this product, the policy will spell out how the insurance company measures the change in an index. There are many different methods.

Some policies use what’s known as the averaging method which calculates the gain (or loss) in the index periodically throughout a contract year. The table below shows an oversimplified example using monthly measurements of what we will assume is an even, steady gain through the year of 12 percent, from 1,000 to 1,120.

In this calculation, the simple point-to-point change was 12 percent (still lower than the real return of the index with dividends). But as you can see at the bottom of the table, for you that gain was reduced to 6.5 percent, the average of the monthly points along the way.

This is the sort of “fine print” that investors rarely pay any attention to until after they realize that what they expected was something quite different from what they thought they would get.

Cap Rate: Sometimes, the market may go up a great deal – perhaps much higher than the limits specified in your policy. You may find a provision in the contract that limits the highest amount you can ever get. In 2003, the S&P 500 appreciated by 28.7 percent, including dividends. Imagine opening your equity index annuity statement early in 2004 to discover your annuity had been credited only 7 percent. You might immediately call your salesperson or the insurance company, only to learn that your contract has a “cap rate” provision that limits the gains that you will be credited, no matter how well the market does. Once again, you’re out of luck if you were expecting to make significant gains in the really good years.

Participation Rate: Now imagine that after a much more modest year, when the index gained 7 percent, you have been credited with a gain of only 3.5 percent, just half of the index’s total return. The reason: A typical index annuity has a clause that limits how much of the index’s gain you will get, usually described as a percentage of the gain. The example above would result from a 50 percent participation rate applied to an index gain of 7 percent.

Surrender Period: If you owned a financial product for five years, you might reasonably expect to be able to get your money out of it after you finally figured out its flaws. But once the insurance companies have your money under their control, they want to keep it. Enter the detail known as a declining surrender charge. Typically, you can withdraw up to 10 percent of the account in any year. But if you want more than that, you’ll have to pay a surrender charge. Most common is a 10 percent fee for withdrawals the first year, declining by one percentage point per year until the penalty is gone after 10 years. Some policies make you wait as long as 16 years and could charge you as much as 20 percent in the first year.

Guaranteed Surrender Value: Typically you will be promised a minimum guaranteed surrender value if you surrender the product at any time or if the index doesn’t perform well over the term of the policy. This is often stated as a percentage of the premium you paid (for example 87.5 percent) plus some minimum interest rate, usually between 1 and 3 percent. As a result of these provisions, your “guaranteed” surrender value is likely to be less than you might expect.

Here’s another issue you should know about if you buy an equity index annuity in a taxable account: Any capital gains you actually manage to earn from this product will be taxed as ordinary income, not at the lower rate for capital gains. This is not the fault of the insurance company; it’s built into the tax laws. There is also no step up in basis at death like there would be for a stock or mutual fund.

Is This Product Right For You?

Should you invest in an equity index annuity? I don’t think this product is a reasonable substitute for investing in equities. Likewise, it is far too expensive, restrictive and complex to be a good substitute for owning fixed-income funds or having a savings account.

Unfortunately, this product produces more financial heartbreak than happiness, mostly because so many investors are so eager to trust a sales pitch without learning the facts. Like the investor I recently spoke with, many thousands of investors will eventually wish they had followed a simple, old-fashioned bit of advice: Investigate before you invest.

If you think I’m being too negative about fixed indexed annuities, I suggest you check out this product online. Here are three links:

•    From the Securities and Exchange Commission website (and likely to be among the first items to pop up in a Google search of “equity index annuity”):

•    From the Financial Industry Regulatory Authority investor site:

•    The transcript of a story on Dateline NBC that shows you the “tricks of the trade” among insurance agents.

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Jeremy Burger

By Jeremy Burger, Chief Executive Officer CFA®, CFP®

As CEO, Jeremy directs Merriman’s overall strategic plan and is focused on ensuring we have the right talent and resources in place to help our clients LIVE FULLY and provide peace of mind throughout their financial lives. In addition, Jeremy is responsible for our inorganic growth effort which seeks to bring together likeminded firms across the western U.S. to better serve our clients.

Jeremy is a CERTIFIED FINANCIAL PLANNER™ professional and a Chartered Financial Analyst®. He is a graduate of Seattle Pacific University with a degree in business administration and a minor in economics. He is also a member of the CFA Institute and the CFA Society of Seattle.

Outside the office, Jeremy spends time with his wife and three daughters, enjoying the outdoors, traveling to new places and supporting those causes most important to them. Jeremy is committed to helping his community and has worked with the Seattle Pacific University mentorship program and actively supports a variety of local charities including the Fred Hutch Cancer Center and those focused on helping disadvantaged children.

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