You probably don’t need this popular annuity product

You may be hearing a lot about cryptocurrency or other “hot” investments, but one of the most popular investment products over the last 20 years has been something called an equity (or fixed) index annuity (EIA). The concept is simple: purchasing an EIA purportedly allows you to participate in market index gains and defer income tax, all while incurring no downside risk. Sound too good to be true?

Following the 2008–09 Great Recession and market downturn, many investors were looking for safer investments than the stock market and turned to EIAs. Sales of EIAs jumped 25 percent in the third quarter of 2018 over the prior year and were expected to exceed $70 billion in 2018, according to LIMRA Secure Retirement Institute. Over $560 billion of EIAs have been sold through the end of 2017.

What are EIAs? 

Fundamentally, an EIA is a tax-deferred fixed annuity that credits interest based on the percentage change in the value of a broad market index, typically the S&P 500 (which tracks the largest U.S. stocks), but which promises no losses if there is a decline in the market index.

How is the return calculated? 

This can be complex and difficult for many people to understand. The insurance company offering the EIA is not actually investing in the index. Most insurance companies are limited by state law to investing primarily in bonds and other more conservative assets. The insurance company allocates a small percentage of its invested assets — typically less than 10 percent — to purchasing options contracts on the market index. The insurance company is simply crediting you interest based on the return of the market index, with some minimal guarantee. Often, the guarantee is that the interest credit will not be negative, even if the market index posts a negative return. The interest is calculated using one of various formulas that determine how much of that percentage change in the index applies to the account value of the EIA. Insurers use various formulas such as participation rates, caps, spreads, or other techniques to limit the amount of interest that can be credited based on the change in value of the underlying market index.

Example 1. An EIA has a participation rate of 75 percent of the change in the value of the S&P 500 index but not more than 7 percent in a policy year. If the index returns 12 percent in a policy year, 7 percent is credited to the account since that is the cap (rather than 75 percent of 12 percent, which would be 8 percent).

Example 2. An EIA has a participation rate of 75 percent of the change in the value of the S&P 500 index but not more than 7 percent in a policy year. If the index loses 5 percent in a policy year, there are no losses in the account.

The calculation of how interest is credited in an EIA can be so confusing that the Financial Industry Regulatory Authority (FINRA), a self-regulatory organization that regulates securities brokers and dealers, issued an investor alert because it was concerned that investors did not understand the complexity of the product. FINRA’s alert points out that an investor may earn far less than the return of the underlying index in a good market and that a purchaser of an EIA can lose money, as most contracts only guarantee return of 85 percent of the premiums paid plus 1–3 percent per year.

One provision of the policies that gets little attention is that the insurance companies typically have the flexibility to lower the participation rate, increase the spread, or lower the cap, which lowers the potential returns. In addition, it should be noted that the index return to which interest crediting is pegged excludes dividends, so your return from an indexed annuity will also exclude the total return benefits of dividend income. Unfortunately, many investors in an EIA believe they are getting full-market index returns with no downside risk.

The misguided appeal of downside protection

The big appeal of EIAs is the downside protection when markets are declining. This is the sales pitch for those selling EIAs, and it is the fear that motivates those buying them. As can be seen from the above examples, a purchaser of an EIA is giving up full-market return potential in exchange for downside market protection. How valuable (or costly in lost returns and flexibility) is this protection?

Stock markets have provided significant returns over time. Since 1926, the S&P 500 Index has been positive roughly 75 percent of calendar years; only about 25 percent of those years have produced a loss. Yes, stock markets mostly go up, and over time they can go up a lot! Since 1928, U.S. stocks have produced an average annual return of about 10 percent, while, for comparison, U.S. Treasury bonds have returned a little more than 5 percent. The long-term average masks the fact that much of those gains can come in years of significant gains.

If we look at the last 10 years ending Dec. 31, 2018, the S&P 500 average annual return was 13.12 percent (10.75 percent without dividends). During that time period, there were only two years when an EIA provided protection against the negative returns in the U.S. equity markets: 2018 (-6.24 percent) and 2015 (-0.73 percent). However, there were seven years where an EIA would have returned only a small portion of the positive U.S. equity market returns. Most of those index returns were significant (dividends are included in total return): 2009 (25.94 percent), 2010 (14.82 percent), 2012 (15.89 percent), 2013 (32.15 percent), 2014 (13.52 percent), 2016 (11.77 percent), and 2017 (21.61 percent). Over the last 10 years, an investor in an EIA gave up significant positive returns in seven years for two years of relatively small declines. That doesn’t seem like a logical tradeoff!

Yet sales of EIAs are still booming primarily because of investor fears resulting from the significant decline in the S&P 500 in 2008 of 36.55 percent, which was scary for many investors. What about those investors who want to protect themselves from such occasional larger market downturns?

(Continued)

The problem being “solved” with an EIA is a behavioral and educational issue and shouldn’t be a product issue

With a little education, most investors should understand that risk and return are related. An investor can’t enjoy returns greater than those of bonds or cash without taking some additional risk, which is defined as market volatility. In fact, market corrections — sometimes severe corrections — are a feature of successful long-term investing, not a “bug” in the system that needs to be fixed. If investors understand and accept this fact about the markets, and get help in understanding this and maintaining discipline from competent advisors, they likely will be much less emotional about downturns and make better long-term decisions.

A competent financial advisor can help an investor develop an appropriate portfolio mix of stocks and bonds or other assets classes that meet the investor’s risk tolerance, such as the alternative portfolio suggested later in this article.

Keep in mind other negative aspects of EIAs:

1. While newer policies may allow for some limited annual access or shorter surrender periods, there may be a significant surrender period for up to 10 years when a penalty applies for withdrawing funds. Given available alternatives discussed below, voluntarily creating an unnecessarily illiquid asset is often a poor choice for most investors.
2. Any interest credited to the account is taxed as ordinary income when distributed. Investments outside of an annuity or retirement plan may be taxed at lower capital gains or qualified dividend rates, or even no capital gains tax for those in the lowest tax brackets. Also, any withdrawals from tax-deferred annuities before age 59-and-a-half are generally subject to a 10 percent tax penalty.
3. Salesmen often receive very high commissions on annuities. There are also administrative and other fees paid to the insurance company associated with maintaining the annuity contract. The purchaser of the annuity is paying for these commissions and fees through the reduced return under the contact cap or limited participation rate. Also, beware of “bonuses” and other incentives to boost returns during the first couple of contract years. If you do decide to purchase an EIA (or any insurance product for that matter), always review the prospectus very carefully and make sure you understand all the fees and costs involved. There is no free lunch!

Does an EIA ever make sense?

The situation where an EIA might make sense is an alternative for a very risk-averse person who normally invests in certificates of deposit (CDs) at a bank or a fixed-rate deferred annuity. The EIA would likely be expected to provide slightly better rates of return than these conservative investments.

Is there a better approach for most people?

Given the concerns about EIAs outlined above, a strong argument can be made that there is a better alternative to EIAs for the majority of the investing public. As scary as 2008–09 was, the likely answer is not to lock up one’s funds in an EIA. To meet the desires of an investor who truly cannot stomach much market volatility and is willing to accept lower expected returns similar to that achieved in an EIA, a simple and understandable portfolio can be constructed with high-quality bonds and a limited amount of U.S. and foreign stocks that will achieve their objectives.

With this portfolio, the investor has complete access to the fund at any time and is avoiding many of the negative concerns with EIAs outlined above. While the account isn’t fully tax deferred like an annuity, using tax-sensitive, low-cost mutual funds or exchange-traded funds with tax-exempt municipal bonds creates a portfolio with little ongoing income tax concerns. Finally, taking advantage of losses that should be expected (and are normal) through tax-loss harvesting could provide additional benefit on an after-tax basis.

Dean T. Stange, JD, CFP, is a principal and senior financial advisor at Wipfli Financial Advisors LLC.

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