If you’re anywhere near retirement age, or if you’re in retirement, chances are you’ve had an Equity-Indexed Annuity (EIA) pitched to you.
Now, if for some reason you’ve missed out on these pitches (Maybe you’ve been out the country? Don’t have a phone? Don’t read your mail?) here’s the gist: Insurance salesman tells you about this wonderful product that allows you to participate in the stock market’s upside, while not experiencing any of the market downside. In today’s stock market climate, sounds pretty good, huh?
A couple of things come into play that the salesguy doesn’t highlight for you:
First, your “participation” in market upside is limited. Typically there is a cap on the amount of market upside that the account will pay out, and in this market climate, the upside potential is tremendous, which will primarily benefit the insurance company, not you. In other words, given that the market has experienced a significant drop, there is high potential for significant increases in the coming months and years. If there is a cap on your upside “participation” of say, 6% or 8%, the rest of the account’s upswing goes to the insurance company’s bottom line.
Now, you might say – that’s a small price to pay for not having to endure a downswing in the market like we have experienced recently. And I would agree with you on that score. However: this is a hindsight statement, because again, the chance is quite small that the market will continue trending continually lower after its performance of late. There often are minimum guaranteed rates of return that can help on the downside as well, but the end result can be that you get back less from the contract than you originally deposited.
And so – the downside protection that you receive comes at the cost of limited upside. The limited upside throttles back your performance in the bull market periods, leaving you with dismal returns overall. But that’s not the biggest issue you face with these accounts…
The second issue is the overall cost of these accounts. Annually, there is a fee charged against the value of the account of between 2% and 3% annually. Doesn’t seem like much, until you think back to the caps that are placed on your account’s participation in the market. Suddenly, that 8% cap becomes 5% when you remove the annual fees. And what about if the market just goes sideways? You still lose 3% to fees every year.
The third issue is the annuity term. As with all annuities, there is a term during which you are not free to withdraw the balance without penalty. The penalty varies but can be steep, as much as 20% depending on the contract. This can cause a liquidity problem – if you need money right away, you might not have ready access to it without paying the penalty.
I just thought I’d give you a brief rundown on these accounts since they’re getting a lot of “push” these days – since the market decline has highlighted their selling points, plus there is a lot of upside potential benefit to the companies pushing them.
There’s a reason equity-indexed annuities are popular: market drops are scary. And sometimes we’ll overlook the downsides to get some protection against scary things.
There’s also a reason equity-indexed annuities are popular with insurance companies: historically, the market returns negative overall results one out of every four years. Plus, the average annualized return of the S&P 500 over the past 50 years has been approximately 11%. So the insurance company has to pay the guarantee only 25% of the time, and the rest of the time (on average) they are able to glean 3% off the top of the contract.
Finally, equity-indexed annuity is one of the only types of investment that FINRA has seen fit to produce an investor alert about. It’s important to have your eyes wide open if you’re considering one of these contracts.