I once attended an investing seminar at which the presenter asked for a volunteer with a five-dollar bill. A gentleman came forward and the presenter said, “Now I will toss a coin. Call it in the air and if you are correct I will double your money. Otherwise, I will give you your $5 back.” The coin was tossed and the man called it correctly and walked away, having doubled his money. The presenter then said, “Ladies and gentleman, you have just seen how an Equity Indexed Annuity(EIA) works.”
The presentation was impressive, but also highly misleading. Who wouldn’t want such a product, with the ability to double your money with no risk? But things are rarely as rosy as salesmen present them, and so it often is with indexed annuities. He was correct that the product guarantees you won’t lose principal (based on the claims paying ability of the issuing company) but he had greatly misrepresented, and overly simplified, the potential upside.
He failed to explain that, though gains are usually tied to a stock market index like the S&P 500, there are caps in place to limit the upside. There are also complex calculation methods that could result in the product making no money at all in some years, even ones when the market index is up. Nor do these annuities include the dividends paid by companies that make up the index. In my mind, worst of all, he did not mention that the insurance company was free to adjust caps on each anniversary, and the client has no recourse if they do. Imagine locking yourself in to a 10-year product where the company can unilaterally lower your rates each year. How much do you trust the insurance company to maintain favorable cap rates?
Though EIAs track a stock market index, their ability to earn money is largely connected to current interest rates, due to the way they function internally. Thus, when interest rates are low, cap rates tend to be lower as well. Investors looking to the safety EIAs might offer should be aware that current cap rates, which are near historic lows, will limit any potential upside.
There are large national organizations that teach agents how to sell indexed annuities using free dinner seminars. I advise investors to be very cautious anytime a salesman has to pay a lot of money to get them to attend their seminar. The financial pressure on the salesman can be high after paying an expensive restaurant bill.
This is not to say you should not consider an indexed annuity. Just be aware that the upside can be very limited and the cap rates may be adjusted each year by the issuer. These annuities can involve long term contracts with high surrender penalties. And finally, the salesman has a significant financial incentive to make the sale.
Indexed annuities may have a place in your portfolio once you understand the costs and limitations, but they are not as simple as flipping a coin, despite what some clever salesmen may infer.
*The S&P 500 is based on the average performance of the 500 industrial stocks monitored by Standard and Poor’s. All indices are unmanaged and are not available for direct investment by the public.
Hi, I'm Dan. I'm a CFP® Professional.
Securities and advisory services offered through Commonwealth Financial Network®.
Member www.finra.org / www.sipc.org , a Registered Investment Advisor. Wyson Financial, 1173 S. 250 W. Suite 505, St. George, UT 84770.
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