Securities Regulator Issues Warnings Regarding Equity-Indexed Annuities
by James J. Eccleston, Esq.
he National Association of Securities Dealers (NASD) has warned its member brokerage firms as well as investors about equity-indexed annuities. These warnings highlight that equity-indexed annuities may not be suitable for investors. They also caution that investors may not understand the features, including the risks, of these products. Let's overview the NASD's concerns, as reflected in its Notice to Members 05-50 issued in August, 2005 and its Investor Alert issued a few months earlier.
Preliminarily, the NASD has issued these warnings even though it recognizes that equity-indexed annuities may not be securities. Indeed, insurance companies usually issue these products, which guarantee a stated interest rate and some protection from loss of principal. However, the products also offer an opportunity to earn additional interest based on the performance of the securities market. This market-based return feature makes the equity-indexed annuity more risky than a fixed annuity.
The NASD has been proactive in view of the increasing popularity of the product, the sales abuses that it has witnessed, and the absence of adequate brokerage firm supervision of its brokers. Annual sales increased over 50% in 2004 from 2003, to $22 billion. In its Notice to Members, the NASD gives some of the following examples of advertising claims:
- "What if the market goes down and you would lose nothing? The market goes up - you gain";
- "Growth Potential without Market Risk"; and
- "How Your Retirement Funds Can Have: Security of Principal, Higher Than CD Rates of Interest, Opportunity for Growth (No Losses).
These no-loss claims are misleading for numerous reasons. In its Investor Alert, the NASD tells investors that they indeed can lose money in equity-indexed annuities: "Many insurance companies only guarantee that you'll receive 90% of the premiums you paid, plus at least 3% interest. Therefore, if you don't receive any index-linked interest, you could lose money on your investment. One way that you could not receive any index-linked interest is if you surrender your [equity indexed annuity] before maturity. Some insurance companies will not credit you with index-linked interest when you surrender your annuity early." In addition, the NASD also cautions that any withdrawals from tax-deferred annuities before age 59 1/2 generally are subject to a 10% tax penalty in addition to having any gain taxed as ordinary income.
Likewise, the NASD is concerned that investors may not understand the features of these complex products. The following are important points to understand. First, many equity-indexed annuities permit investors to participate only in a stated percentage of any increase in an index. Second, many products impose a "cap rate" that represents the maximum annual account value percentage increase allowed. Third, equity-indexed annuities not registered as securities typically do not allow investors to participate in dividends accumulated on the securities represented by the index. Fourth, other features, such as fees and expenses, carefully must be studied. Fifth, and perhaps most important, investors should determine whether the particular equity-indexed annuity allows the insurance company to change the deal - participation rates, cap rates or other features - either annually or at the start of the next contract term.
Overall, the NASD cautions its brokerage firm members that equity-indexed annuities may not be suitable for investors given such considerations as the possible surrender charges as well as the combination of caps and participation rates associated with a particular product.
In conclusion, before investing in an equity-indexed annuity, be sure to investigate and understand its features, including its risks.
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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.
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