Equity Indexed Annuities

There has been a lot of controversy over Equity Indexed Annuities (EIAs), since they were introduced by the insurance industry in the mid 90's. Professionals that sell them believe they are just what a risk adverse investor is looking for, while others believe they are nothing more than smoke and mirrors. If you take a careful look at them you will find that the answer is somewhere in the middle.

An EIA is an insurance product that seeks to capture a portion of market gains, while not realizing any downside market losses. Sounds interesting doesn't it?  EIA contracts typically guarantee a minimum interest rate, typically 3 percent, regardless of what the market does and when the markets appreciate, typically 80 to 90 percent of any market appreciation. So the story is you can invest your money with no risk. A worse case scenario is your money returns 3 percent in a down market and 80 to 90 percent in an up market.

But like most things in the financial products arena…buyer beware. Said another way, read the fine print before you purchase an EIA contract.

In order to understand why this is so, we need to follow the money from your hands to the insurance company's hands to find out what really happens.

When you purchase an EIA contract your money is not really invested in the stock market. The insurance company typically will invest a portion of your premium in the options market and invest the rest in bonds or other lower risk investments. Using options as a hedging strategy, and bonds the insurer can guarantee a base rate regardless of what the markets do since if the S & P 500 Index plunges for example, the options lapse as worthless and the base rate is provided by the bonds.

Investors receive interest based on the movement of an index like the S & P 500 Index using something called a participation rate. And this is the rub. The participation rate limits the amount of market gains you receive and is usually expressed as a percentage of a market index. Depending on the insurance company and product, this participation rate can vary from 35 to 100 percent of a market index like the S & P 500 Index for example. Usually (read the fine print) if the participation rate is advertised at 100 percent, there is a cap that is used to limit the gains to high single digit returns for a given year. To make matters worse the calculation of returns is many times based not just upon a change to a market index, but uses an averaging method that effectively further reduces the upside and downside by as much as 50 percent of an index change.

EIAs are usually "pitched" as safe investments, because the return of your principal is guaranteed. Well…almost. The guarantees usually applies if you hold the investment to maturity which is usually between five and ten years. If you decide to cash out early, like most annuity products there are surrender charges which can vary from 5 percent to as high as 20 percent.

If you look carefully at EIAs and consider the limitations of upside gains and early withdrawal charges and the complexity (these products are not easy to understand) it really doesn't seem like a good choice. The "pitch" is usually market gains with little or no risk, but if you look carefully you will find that a well diversified portfolio can produce higher returns at a much lower cost.

Should you avoid EIAs? Not necessarily, but there are several excellent, better performing alternatives that you should consider first.

Back