| 03 September 2004
I am seeing more and more people come into my office having been sold or proposed equity index annuities as an investment. These are becoming quite popular as insurance companies attempt to capitalize on investors’ fears of the stock market. My advice, though – when you are approached by an insurance salesperson about buying an equity index annuity – is to turn and run the other way as fast as you can!
Insurance companies are very creative in coming up with new products to sell – and insurance salespeople are quite adept at pitching whatever will earn them the highest commission.
Before discussing this fairly new product, though, it would be worthwhile to review annuities in general. Annuities come in two basic flavors: fixed and variable. Both are investments offered by insurance companies whereby the gains are tax deferred until the money is withdrawn.
Fixed annuities are like interest bearing accounts at the bank such as CDs. As such, they offer a low return for the security that they will not decline in value. The primary risk is that they will not allow an investor to keep up with inflation. Fixed annuities do not carry excessive costs, and therefore, are a reasonable investment for very conservative investors who don’t mind tying up their funds for several years. Keep in mind, though, that with all insurance contracts the investment is only as solid as the company itself.
Variable annuities are like mutual funds because the investment responsibility (and risk) is passed on to the investor. The idea is to offer growth investments within the context of the annuity, although variable annuities contain some conservative options as well. Unlike fixed annuities, they have higher annual fees and most have stiff penalties for getting out prematurely. They also limit the number of investments that you can choose. But maybe the biggest drawback is that they defer income tax until a future time to be taxed at your ordinary income tax rate (often 25% or higher). Alternatively, you could invest in regular mutual funds and pay some taxes currently, but at the lower dividend and capital gains rates of 5% to 15%. Why defer taxes for the privilege of paying at a higher rate?
In 1997, I stopped recommending variable annuities when the tax laws changed and eliminated the tax advantages over regular mutual funds. More recent tax law changes have made annuities even less attractive. It is sometimes appropriate to transfer from one annuity into a lower cost annuity - but because the tax laws favor other investments – I never recommend them for new investment dollars.
The worst offense is when variable annuities are sold in tax deferred accounts. It is never appropriate to use a variable annuity within a tax qualified retirement account such as an IRA or 403(b) plan. The main feature of an annuity is the deferral of income taxes until the money is withdrawn. A retirement account provides tax deferral anyway and, therefore, there is no additional benefit to the annuity. However, a variable annuity has higher annual fees and the other disadvantages mentioned above.
Special bonuses paid to the investor often make annuities an easy sale, but these bonus contracts have higher surrender charges and longer surrender charge periods. And so-called guaranteed rates are often not as high as you were led to believe. The only thing that is guaranteed is that the salesperson will receive a hefty commission.
In Detroit, we are accustomed to the launch of new car models. But with equity index annuities it is like putting a new coat of paint on an old jalopy!
Aside from my general distain for variable annuities – and the sales practices of the insurance companies - the equity index annuity comes with its own baggage. The idea behind the product is good - but as with most insurance products - they are complicated, inflexible and expensive. These are three characteristics you definitely do not want in an investment.
The equity index annuity is actually a form of fixed annuity that offers the potential for excess interest based on the performance of an index, such as the S&P 500 equity index. This makes it a cross between the standard fixed annuity and a variable annuity in terms of the expected rate of return. The idea is to offer the investor a guaranteed rate to protect them on the downside but also the chance to enjoy the upside of the stock market. But we all know that you can’t have your cake and eat it too!
The guarantee feature does provide protection on the downside – but the yield can be extremely low – and you give up much of the potential upside because there are various mechanisms to cap what you can earn, such as the participation rate whereby the contract holder only participates in a percentage of the growth in the index. Also, the formula does not give the investor the dividends produced by the companies in the index - just the change in the index value (price) – which historically have provided a large portion of the total return from stocks.
Equity index annuities are a good example of the old adage – insurance is not bought - it’s sold. They are difficult to understand - intentionally so, I think - even for a trained financial professional. For this reason alone, I recommend that investors avoid them. When you combine this with the other disadvantages of annuities, it is clear that there are better ways to invest your hard earned dollars.
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