I decided to write the post below after Scott Dauenhauer, a financial planner I admire, sent me a link from an annuity firm that rails against all the bad press that Equity Index Annuities have deservedly been receiving. After you read the spiel, I hope you’ll be as appalled as I was. (Though I wasn’t surprised.)
An elderly woman, who lives in our community, learned not too long ago that she needed dentures. She had enough cash to pay for the new teeth, but she discovered that her money, while technically hers, couldn’t be touched.
The bad guy in this pitiful case was an insurance company, which had capitalized on an ingenious way to make money off an easy mark. What the woman with the bad molars bought was an equity indexed annuity. Promoters attract unsophisticated investors by suggesting that buying an EIA is like owning a handful of magic beans and a golden goose. An EIA, they say, will allow you to enjoy stock market gains without facing any of the risks. After listening to the spiel, it would be easy to conclude that only a chump would continue to invest in mutual funds or individual stocks. If you dump your money into one of these annuities instead, your EIA flak jacket will withstand all the nasty stuff that Wall Street tries lobbing at you.
In reality, however, EIAs aren’t a miracle investment. And they certainly aren’t risk free for those who experience buyer’s remorse. Hidden inside these things are incisors that can tear a customers’ investment apart if they decide to bolt.
EIAs are actually complicated insurance products that are being marketed to senior citizens, who are terrified by stock market losses. The upside potential for EIAs, say the salesmen, is great, but if the markets crash, an EIA’s return can’t dip into negative territory. These annuities guarantee a base annual return for the length of the contract, which is often 3%.
One drawback to EIAs is their complexity. While many EIAs, for instance, are partially linked to the fortunes of the Standard & Poor’s 500 Index, there are plenty of ways that an insurer can shrink the annuity’s return. For starters, a customer might be promised a 50%, 70% or even 100% share of the S&P 500’s annual performance. But that’s misleading because an EIA excludes the S&P 500’s dividends as part of the return. Insurers also often put caps on the returns that you can capture. Just how much the performance will shrink can depend on which of the dozens of crediting methods that an insurer uses. “There are probably 100 different ways to credit interest in an EIA and you literally need a degree in industry methodology to understand,” suggests Scott Dauenhauer, CFP, who is president at Meridian Wealth Management in Laguna Hills, CA.
Critics contend that many of the best-selling EIAs rely on crediting calculations that provide customers with the most anemic returns. Why would someone recommend an EIA that stinks up the room? Hmm. Would it shock anybody out there when I said that some insurance agents routinely select the EIAs that provide the highest commissions for themselves? Many popular EIAs pay agents 8%, 10% or higher. Some lucky guys can even get 12% on a sale.
Because the sales commissions are so generous, insurance companies need the buyers to stay put for a long period of time so the insurers can recoup what they paid the agents. They keep customers in their seats by hitting them with surrender charges if they try to bolt. EIAs, however, will typically allow investors to pull out 10% a year without a penalty. Surrender periods will sometimes last longer than the clients. Imagine a 80-year-old widower buying an EIA that locks up her cash for 15 years. It was one of these lengthy lockup periods that tripped up the woman needing dentures.
Ronald A. Marron, an attorney in San Diego, who has filed numerous lawsuits against EIA insurance providers, including two class action suits, says he’s seen surrender charges as high as 25%. But Marron insists that ditching an EIA can involve more than paying the surrender costs. He says one of his clients, who sunk $1.495 million into an EIA, would have had to pay $263,000 to bail after being hit with a double whammy—a surrender penalty and something called a market value adjustment charge.
There are other reasons why EIAs are troubling. Insurance agents, who don’t possess securities licenses, are forbidden from selling stocks, bonds, mutual funds or even a lowly certificate of deposit. They can, however, sell all the EIAs they want thanks to the way they are regulated. The U.S. Securities and Exchange Commission and the NASD don’t consider EIAs to be an investment–at least not yet. Consequently, these regulators don’t have the authority to tell agents, who often market EIAs through free seminars, what they can or can’t do even if the advice is reckless. Some EIA promoters, for instance, are urging people to refinance their houses or take out reverse mortgages so they can free up cash to buy EIAs. Obviously, that’s just nuts. The NASD did issue an investor alert on EIAs last year, which you can find on the regulator’s web site (www.nasd.com). It’s also auditing EIA practices at some brokerage firms, while the SEC is conducting its own investigation.
The NASD urges investors to understand how a particular EIA works before buying one. But that’s a recommendation that even the people selling these complex annuities could have trouble following.