By Rich Todd, Managing Principal, CEO and Jared Martin, CFP®, AIF, Vice President
Equity-Indexed Annuities (EIAs) are complicated financial products with considerable disadvantages. However, EIAs are often sold by annuity salespeople who may be motivated by sizable commissions, rather than their client’s best interest. It has become increasingly clear to us at Innovest that many people who have invested in these products will not receive what they expect. In this article, we will review EIAs and how their earnings are calculated, explore the issues that arise from salesperson compensation, and examine a recent case study.
What is an Equity Index Annuity?
With an annuity, you exchange a certain amount of principal up front for payouts by an insurance company in retirement. The payouts for EIAs, sometimes called “index annuities”, are somewhat based on the performance of an equities index, like the S&P 500. If stock prices rise during a specific time period, EIA owners receive an interest rate based on the partial rise in stocks. If stocks fall, EIA owners earn a minimum interest rate. FINRA (the Financial Industry Regulatory Authority) describes EIAs as “having characteristics of both fixed and variable annuities. Their return varies more than a fixed annuity. EIAs offer a minimum guaranteed interest rate combined with an interest rate linked to a market index.”
How are earnings for EIAs calculated?
Earnings for EIAs are calculated somewhat differently than traditional annuities. Generally, the insurance company that sells the EIA will declare an index participation rate—or a percentage of the index’s gain—that is promised to the annuity owner. If the participation rate is 80%, the investor will be credited with 80% of the index return. Also, many EIAs have a maximum cap that limits how much gain can be received over a defined time period Importantly, dividends are typically not included in the return calculation of the index. Dividends are a key component in total market return and help to reduce volatility. The exclusion of dividends is a real cost to the investor. The recent S&P 500 dividend rate is 2%. As Ethan Schwartz of The National states, “the S&P 500 isn’t’ travelling at full speed” when dividends are excluded.
The second component, like a fixed annuity, is the declared rate component. This rate is typically paid on at least 87.5% of the investment and is usually a 1% to 3% interest rate.
The third component is the “spread” per cost, a deduction against the return, which typically ranges between 1.5% to 3.5%.
Here is the formula:
Index Returns (without dividends) + Declared Rate - Spread = Earnings
How are earnings taxed?
Earnings are deferred until distributed to the annuity owner. Distributions are taxable at ordinary income tax rates. There is no tax advantage to owning an annuity in a retirement plan or an IRA.
What about the costs?
Spread – 1.5% to 3.5% per year
Dividend elimination – for the S&P 500, it was recently 2%
Surrender charges – if the annuity is sold within the first five to 10 years, the owner pays a charge of 4% to 10%
The salesperson earns a commission from the spread of the product, either front-loaded with a typical commission of 5% to 10% of investment. The higher the spread, the higher the commission to the salesperson– a significant conflict of interest. Further, these salespeople are not legal fiduciaries. Fiduciaries offer advice only in the best interest of their client, while non-fiduciaries do not have this obligation. In addition, the surrender charges are in place primarily to compensate the insurance company for the commission paid to the salesperson.
Two regulatory bodies – the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) -- have offered instructive notices on EIAs. FINRA, predecessor of NASD (The National Association of Securities Dealers), has noted: “NASD is concerned about the way an associated person is marketing and selling unregulated EIAs, and the absence of adequate supervision of these sales practices. For example, FINRA has heard the following claims:
‘What if the market goes down and you would lose nothing? The market goes up, you gain!’
‘A win/win Investment vehicle’
‘How your retirement funds can have security of principal, higher than CD rates of interest, opportunity for growth (no losses)’
‘Pick up where Social Security leaves off with new tax featured annuities… featuring… two indexed accounts linked to a popular market index’
‘If you’re looking for upside potential and no market downside, look no further than (name of EIA). This fixed annuity… enables you to make the most of S&P 500 index gains…’
‘Growth potential without market risk’”
According to FINRA, investors are being misled by these sales tactics.
A participant in a retirement plan recently took a lump sum distribution out of the plan to invest in an EIA instead of keeping her assets in the plan. The total investment and recordkeeping costs in the retirement plan were less than 0.70%. It was explained by the salesperson that there would be “no fees” in the EIA and that it offered protection that she did not have in the plan.
Here were the characteristics of the EIA sold to the participant:
Spread cost of 2.25%
Surrender charge starting at 9% for the first four years, then declining by 1% per year for the next five years
The declared rate was 1% on 90% of the investment
The future dividends of the index would not be included in the investor return
“The insurance company pays me,” the salesperson said. On a $200,000 investment, the salesperson made either $14,000 up front or $2,000 per year for nine years ($18,000), paid directly from the investment. The compensation came directly from the insurance company’s profits created with the annuity purchase.
The low returns of EIAs combined with high costs typically don’t make EIAs worth it. By having a sound process for portfolio design and prudent asset allocation, downside risk can be reduced through much lower costs than EIAs. At Innovest, we believe that most EIA purchasers have expectations of higher earnings than they receive because of the dividend elimination and high costs. Further, annuities do not offer any tax advantages as compared to a traditional retirement plan—withdrawals from both are taxed at ordinary income rates. Assets invested outside of a retirement plan can help defer taxes through low-turnover investments, and eventually asset sales should be at a long-term capital gain rate, not ordinary income like an annuity or a retirement plan.
Salespeople prey on retirement plan participants looking for big sales with a “product that a retirement plan can’t offer.” These participants are better off taking advantage of plan education services that lead to a sounder and much lower cost approach.
1. Notice to member. NASD August 2005 Guidance. Equity Indexed annuities.
2. Investor Alert. FINRA Equity Indexed Annuities: A Complex Choice