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Equity Indexed Annuities

By: Investor Solutions

By: Investor Solutions

I’m not sure how many of you have heard the song that goes, “Ready, ready, ready, ready to run…” by the Dixie Chicks but that’s what we should all do when we come face to face with an annuity salesperson. For those of you who are long time readers of The Informed Investor Newsletter you probably already know how our advisors feel about annuity products. If asked whether or not you should purchase an annuity our advice 99.9% of the time would be to run. Run fast and in the opposite direction of the annuity salesman. However, clients continue to ask whether or not annuities are a good investment vehicle and we continue to meet prospects who have been coerced into purchasing an annuity in spite of their better judgment.

The reasons why annuities are ineffective investment vehicles are numerous. For starters, annuities are extremely expensive. Insurance charges, maintenance fees, management fees and surrender charges are all present in annuity products. Additionally, annuities restrict the investments available to the owner to subaccounts, discussed later. Annuity income is taxed at higher ordinary income tax rates (up to 35%) rather than lower capital gains tax rates (up to 15%). Annuities also lack liquidity that may be necessary should unforeseen financial circumstances force the sale of investable assets. Early distributions, before 59 ½, from an annuity are subject to a 10% penalty. In spite of all of these downfalls, investors continue to get hoodwinked into buying these products because they are told that they are tax deferred and safe. As such, I find it best to inform investors of the different types of annuities available and their limitations.

Tax deferred annuities are contracts between you the owner and an insurance company. You pay the insurance company either a lump sum or a series of payments over a term of years in exchange for a stream of income for a term of years or for the rest of your life. If you purchase an immediate annuity, your annuity income stream begins, surprise, immediately. If you purchase a deferred annuity, the payments you receive will begin at a future date. As we discussed earlier, the earnings on this annuity are tax deferred up until you begin to receive the annuity income.

There are basically three types of tax deferred annuities: fixed, variable and equity-index. Fixed annuities are those whose payment is, well, fixed. It provides a guaranteed rate of return that will inevitably not keep up with inflation. It is possible, however, to include an option in a fixed annuity for the payments to increase by an amount, usually 3%-5% annually but it comes with a steep price tag.

A variable annuity, in contrast, gives the buyer the option of choosing his or her investments from a range of “subaccounts” comprised of stocks, bonds, mutual funds or money markets offered by the insurance company. These subaccounts carry the same name and are managed by the same managers as publicly offered mutual funds available outside an annuity. Their expense structure, however, differs and is typically greater than those of publicly offered funds. As their name indicates, the return of a variable annuity is not stable and will fluctuate along with the market. The upside, obviously, is the possibility of an increased return and a larger stream of income. In contrast, however, the possibility also exists that the market will not do well and your annuity income will suffer as a result. Because of the potential for additional income, the variable annuity provides for inflation protection.

An equity-index annuity is a fairly new option within the annuity market. It is a type of fixed annuity that is linked to an index (S&P 500, Russell 2000, etc.) and provides greater earnings potential than a traditional fixed annuity but less volatility that an outright investment in the stock market. While the owner does not have the option to select the investment, he or she chooses an annuity based on the index it tracks.

The indexing method is used to measure the change in the index. The most common indexing methods are:

  • Annual reset method: interest is determined annually by comparing the value of the index at the end of the contract year with the value at the beginning of the contract year. Any interest calculated is added to the annuity value during this time period.
  • High-water mark method: interest is calculated by looking at the index value at numerous points during the term and is based on the difference between the highestindex value and the value of the index at the start of the term. Interest calculated is added to the annuity value at the end of the term.
  • Point-to-point: interest calculations are the difference between the index value at the end of the term and the index value at the start of the term with interest added at the end of the term.

The equity-index annuity has a cap rate and a floor on the earnings and loss potential. Because this type of annuity provides a guaranteed minimum return dependent upon the contract, it comes at the expense of a limited upside potential. This limited upside potential is based on a percentage called the participation rate and it works as follows. Let’s assume that the insurance company declares that the participation rate is 90%. Then, let’s assume, that the index gained 12%. The maximum return, therefore, will be 10.8% (12% * 90%). Another way the insurance company might limit the return on this annuity is by excluding from your earnings the dividend return of the investments within the annuity. The floor is most commonly set at 0%.

Now that you are well informed regarding the types of annuities available and why they are a bad idea, how should you proceed with investing your hard earned money? You will be far better served as an investor by utilizing tax deferred vehicles such as IRAs or 401(k)s during your working years. Additional savings in excess of the allowable limits for the deferred accounts should be invested in a taxable account making sure to hold the investments in these for more than a year so as to take advantage of the lower capital gains rates. Utilizing index funds and exchange traded funds in your portfolio will keep your investment costs down and net return up. You will have effectively, increased your return, decreased your cost, kept your taxes at a minimum and provided for liquidity. So lace up your shoes and get ready to run.