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COMMENTARY | Would you invest in this product?
"In exchange for your retirement nest egg we will guarantee you the following product will participate in the gains of the market. By gains we don't mean you receive the market gains, but every year we will credit you an amount that is based on the returns of a stock market; but not the dividends (which have historically accounted for ~3% of the market returns). We also limit what we will pay you each month (but only on the positive side of the equation) to the point you may not receive what a certificate of deposit at the bank pays. This promise is only as good as our ability to stay solvent. And if you find that you don't like it, you can only take out 10% per year, or suffer a penalty of 10% (which we may impose by going back in time and removing interest credited for the year)."
No? Unfortunately, indexed-annuity products are not likely marketed this way. In my local Detroit area there are a few advisors who have infiltrated Christian and news radio and advertise these products as the savior for retirees. They are products that allow for market participation, but eliminate the losses, they claim. They forget to mention the details, and that you may have a lot more to be concerned about an insurer playing with your retirement fate than the volatility in the markets.
In a working paper titled An Overview of Equity-Indexed Annuities, Craig McCann, PhD and Dengpan Luo, PhD estimate "between 15% and 20% of the premium paid by investors in equity-indexed annuities is a transfer of wealth from unsophisticated investors to insurance companies and their sales forces."
Sounds a little bit different than the positive spin the radio guys put on them.
I have always estimated that these products will compensate investors at a rate similar to that of a bond. In researching one for a client lately, I found that estimate may be optimistic.
The annuity has many ways of limiting the interest paid to an investor. The returns are based on a market index and formulas so complex that it's doubtful any investor has attempted to calculate the returns they should expect. I attempted to review one recently, and then realized that the insurer changed the cap rate every year. With the ability to limit gains by changing the rules, an analysis is simply impossible, though you can be sure that this game will not benefit the investor.
In fact, this particular annuity had done nothing but further restrict the amount the investor could earn over the last few years. A comparison based on historical market performance led me to believe that the initial limit would have provided this investor with the returns similar to that of a one-month Treasury bond. With the limit reduction, the returns were not as favorable.
The main reason you may hear about these products is the fact the high commissions provide for ample revenue streams to pay for radio time, free lunches, and so on. Also, because the insurer must recoup that commission, you face long surrender charges in equity-indexed annuities; in many cases ten to fifteen years.
McCann and Luo rightfully point out that insurers added "trivial benefits, disadvantageous tax treatment and exorbitant costs" to otherwise available securities in order for their agents and advisors to be able to market them as a unique product. The same advantage can likely be recreated by an allocation to government backed bonds and equities or options for significantly less cost.
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