Equity-Indexed Annuities; Understanding A Complex Product To Protect Investors' Interests

ales of equity-indexed annuities, a relatively new annuity product, have grown considerably in recent years. One problem is that they (like all annuities) often can be difficult to understand. Investors need to be familiar with indexing features, indexing methods and other concepts that may work to their disadvantage. Importantly, most equity-indexed annuities are structured so that they are insurance products and not securities, thus eliminating securities law protections such as customer suitability, disclosure and sales practice requirements.

Thankfully, the National Association of Securities Dealers (NASD) has issued helpful guidance, which can be found at www.nasd.com/investor/alerts/indexed_annuities.htm. Let's summarize that guidance.

The first basic point to understand with equity-indexed annuities is that they can be deferred or immediate. That relates to when the investor chooses to receive the periodic payments from the insurance company. Investors buy those periodic payments by paying the insurance company a single payment or a series of payments called premiums.

The second basic point is that equity-indexed annuities are a combination of a fixed annuity and a variable annuity. Those terms relate to the rate of return on the premiums that investors pay. Fixed annuities pay, and guarantee, a fixed rate of return. Variable annuities pay, and do not guarantee, a rate of return that may be positive or negative. That is, investors can lose money because the rate of return varies with the stock, bond or money market fund that the investor chooses as the investment option (known as the subaccounts). As a combination of both variable and fixed annuities, the equity-indexed annuity has both characteristics. Thus, these hybrids offer a minimum guaranteed rate of return combined with a rate of return linked to a market index. That means that equity-indexed annuities have less risk than variable annuities but more risk than fixed annuities. By the same token, in rising markets, these indexed products will not perform as well as variable annuities invested in the same indexes.

Let's look at the fixed part of the equity-indexed annuity. What is the guaranteed minimum return and how good is it? Typically, the guaranteed minimum return is 90% of the premiums paid at a 3% annual interest rate. Therefore, if an investor receives no index-linked return, discussed below, the investor could lose money on this investment. Also, the NASD advises that the guarantees only are as good as the insurance company. Thus, investors should investigate the financial strength of the insurance company offering the annuity.

Next, let's examine the equity-indexed part of the equity-indexed annuity. Although many indexes exist, most equity-indexed annuities are based upon the S&P 500. To determine what the "interest rate" (that is, return from the index chosen) will be, however, investors must understand the indexing feature (or combination of indexing features) that the equity-indexed annuity is using. The NASD cautions that this determination can "dramatically impact" the return on the investment.

The most common indexing features are: (1) Participation Rates; (2) Spread/Margin/Asset Fee; and (3) Interest Rate Caps. The NASD advisory defines each of these. For purposes of this article, investors should note that all of these features have the effect of giving them a lower rate of return than the pure index would have given (the difference being insurance company profit). Also note that some insurance companies give themselves the right to change the deal; they can change any of these index features either annually or at the start of the next annuity contract term.

In addition to those indexing features, investors need to know indexing methods. These indexing methods are used to determine the change in the relevant index over the life of the annuity. Like indexing features, these indexing methods impact the return on the investment. There are three indexing methods: (1) Annual Reset (Rachet); (2) High Water Mark; and (3) Point-to-Point. Again, there are advantages and disadvantages to all of these indexing methods, detailed in the NASD advisory.

Furthermore, investors must understand whether the insurance company will index average, how it will calculate interest and whether it will exclude dividends. Regarding index averaging, this can be done either on a daily or monthly basis and is used as an alternative to calculating an index's value on a specific date. As for interest calculations, the NASD cautions that this can make a "big difference" in the rate of return, depending upon whether the rate of interest is simple or compounded. Regarding the possible exclusion of dividends, look for the rare equity-indexed annuity that counts dividends as part of the total index gains.

Finally, the NASD recommends that investors not even consider purchasing an equity-indexed annuity unless they have made their maximum contributions to their 401(k) plans and other before-tax retirement plans. The reason is that plans such as 401(k) plans allow investors not only to defer taxes on income and investment gains (like an annuity), but contributions to such plans are tax deductible. It also is important to consider that, while investors can withdraw money out of equity-indexed annuities (like any annuity), doing so early (before age 59½) generally results in a 10% tax penalty (in addition to any gain being taxed as ordinary income). Likewise, such withdrawals from any annuity may be subject to the assessment of a surrender charge, which can be substantial.

The NASD also lists additional resources to review. Investors should review them, as well as consult a professional besides the annuity salesperson to determine whether (and, if so, which) equity-indexed annuity is appropriate for them.

_______________________________________________________________________
James J. Eccleston is a securities attorney, representing customers as well as brokers and brokerage firms nationwide in arbitration, litigation and regulatory matters. He maintains an informative website at www.FinancialCounsel.com. He is an equity partner with Shaheen, Novoselsky, Staat, Filipowski & Eccleston, and can be reached at 312-621-4400.