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Equity-Indexed Annuities: The Magic Bullet?

Roger Wohlner

Let's be clear, while I'm not a fan of these products, I'm not dismissing them either. My major beef with Equity-Indexed Annuities (EIAs) and related products with similar names is the way they are sold. This often involves preying on the fears of investors as a major theme.

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According to FINRA's website: "EIAs are complex financial instruments that have characteristics of both fixed and variable annuities. Their return varies more than a fixed annuity, but not as much as a variable annuity. So EIAs give you more risk (but more potential return) than a fixed annuity but less risk (and less potential return) than a variable annuity. EIAs offer a minimum guaranteed interest rate combined with an interest rate linked to a market index. Because of the guaranteed interest rate, EIAs have less market risk than variable annuities. EIAs also have the potential to earn returns better than traditional fixed annuities when the stock market is rising."

First of all, in my opinion, no financial adviser should lead with the suggestion of a particular financial product. This is akin to a doctor suggesting brain surgery when he hasn't even examined the patient. The right way to start a financial relationship is via a financial plan. Only then should implementation via financial products begin.

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Understand that EIAs and many other variations of this type of product are quite lucrative for the registered rep. While this in itself isn't bad, potential buyers of EIAs need to understand this and to realize that these lucrative payments are coming out of the returns they could be earning and could be behind the enthusiasm many reps have for selling EIAs.

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FINRA cites several concerns and suggests asking many questions before purchasing an EIA. A few of these concerns are summarized below.

What is the guaranteed minimum return? In some cases, this can be less than the full premium amount. There is usually some minimum interest rate as well.

How good is the guarantee? These products and any minimum returns are guaranteed by the insurance company issuing the contract.

What is a market index? Typically, these contracts will be tied to a stock market index like the S&P 500, the Russell 2000 (small-cap stocks), the EAFE (a foreign stock index), etc.

What is the participation rate in the index return? Typically, these products will participate in some percentage of the gain of the index, but less than the entire amount.

Is there an interest rate cap on my gains? Many of these products impose a cap on the amount of interest that you can earn in a given period. If the interest rate cap is 8 percent, for example, and the underlying index gains 16 percent, your gain is limited to 8 percent.

What method of tracking the index is used? If the product uses the point-to-point method, for example, interest may be based on the change in the index at two points in time, say the beginning of the contract and the date of maturity. If the index is rising throughout the holding period, but experiences a sudden drop near the end of the contract, your interest rate (return) will not take those prior gains into account. There are other methods or calculating the interest rate, and it is vital that any potential investor fully understands these calculations.

Can I get my money out early if needed? Getting out early could involve a loss of principal and often can trigger some onerous surrender charges. There could be income tax implications as well. Make sure you fully understand the implications of early withdrawal before investing any money in an EIA. If the EIA is held in a tax-deferred account, you could also be subject to a 10 percent early-withdrawal penalty.

One of my biggest objections centers on the fact that while minimum guarantees and equity index participation are great concepts, it doesn't necessary follow that investing in one of these will help you reach your financial goals. Nonetheless, while the last ten years have been rough in the stock market, investors employing a prudently diversified portfolio have fared reasonably well.

Might an EIA work as part of a diversified portfolio? Perhaps, but like any financial instrument, it is a tool, and many questions need to be asked before investing.

Roger Wohlner, CFP(R), is a fee-only financial adviser at Asset Strategy Consultants based in Arlington Heights, Ill., where he provides advice to individual clients, retirement plan sponsors, foundations, and endowments. He recently cofounded Retirement Fiduciary Advisors to provide direct investment and retirement planning advice to 401(k) plan participants. Follow Roger on Twitter and LinkedIn. Roger also blogs at Chicago Financial Planner.

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