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Toxic Product Alert: Avoid Equity-Indexed Annuities

By: Frank Armstrong

*As seen on Forbes.

Upside with downside protection. Especially after the unfortunate adventures of 2008-2009 isn’t that what everybody wants? A product touting those features should sell like hotcakes, so naturally Wall Street is just too happy to supply it – Even if the product isn’t very good, it will sell. Which brings us to the equity linked annuity, a product so poorly understood and toxic that even FINRA noticed.

Most investors dislike loss. And we know that they dislike it more than twice as much as they enjoy gain. Unfortunately, given this risk aversion bias some investors make poor choices. Wall Street has mastered the art of guiding investors to make sub optimal decisions.

As background remember the basic risk-reward line that starts at the zero risk asset and passes through some version of the global equity portfolio. The line thus formed should be considered the natural limit of expected returns at any particular risk level. It’s delusional to think that your portfolio is going to generate returns above this line. For all practical purposes you may consider this almost a Law of Nature. Consistent returns above the line just don’t happen.

On the other hand, it’s perfectly possible to generate returns far below the line. Many investors end up far below what they should have earned given the level of risk that they assumed. Indexed linked annuities give you an opportunity to do just that. But, of course, you will have the satisfaction of knowing that your agent and his company are benefiting richly while taking no risk at all.

FINRA’s investor protection alert, Equity-Indexed Annuities—A Complex Choice, points out that among other problems depending on the specific market conditions an investor may earn far less than she might with a fixed annuity in a poor market while profiting far less than the return of the underlying index in a good market. For instance the downside protection guarantee might be 85% of the purchase amount plus 1-2% per year. So, the total return might be less than zero over the contract life. Even this meager protection disappears in the event of premature surrender. Meanwhile upside potential is severely limited by fees, caps on performance, and the failure to include dividends the index earns as part of the calculation.

The equity indexed annuity contract is so complex that I would be surprised if one investor in a thousand understood it. Worse yet, I doubt that one annuity salesman in 100 understands it beyond the talking points he is supplied with. One thing they invariably do understand is that the product pays far higher commissions than other available choices. So, we shouldn’t be surprised that a highly motivated commission driven agent can make that product stand up on the table and dance.

It’s expensive to get substandard products. The market offers far more effective, economical, tax efficient and straightforward solutions. The siren song of downside protection with upside potential comes at tremendous cost.

Investors would be far better off to limit their downside exposure by trimming their global equity holdings to an amount that meets their risk tolerance and investing the balance into a quality short term bond fund. Then they should expect to be fully rewarded for the risk they can bear while sleeping comfortably at night with a comfortable cushion of fixed income assets.