Don’t Fall into the Equity Indexed Annuity Trap


Following a year in which stocks have dropped by more than 40%, brokers and insurance salesman are aggressively pushing the Equity Indexed Annuity (EIA) as an investment by which an investor can participate in the upside of the stock market without any exposure to the downside. As a smart investor, you shouldn’t fall for this sales pitch because it is not true.

The Securities and Exchange Commission has recognized the abusive sales practices and confusing nature of these products. It recently passed a rule requiring strict regulation of EIAs.

Equity indexed annuities are complicated, but essentially they work like this: You invest a lump sum for a set period of time, typically 10 years or longer. You are guaranteed a minimum annual rate of return, usually about three percent. If the market rises more than that, your annuity can grow up to a point. Meanwhile, the issuing insurance company promises that the annuity will never decline in value (as long as the insurance company remains solvent)..

From there, it gets much more complicated. There are variations between annuity products as to how much fees are charged, how long the contracts last, what sales restrictions may apply to the annuity, and most importantly, what range of gains in the stock market you can expect.

On this last point, the annuities can be particularly complicated. The bottom line, however, is that you will not get stock market-like returns for a number of reasons:

  • Stocks’ dividend yields are not included when calculating your index return. This shaves two to three percentage points per year in performance. In addition, most annuities set a ceiling for what you can earn, regardless of how well stocks perform in general. These so-called “performance caps” typically limit your participation in stock market increases to about eight percent per year, even when the stock market rises, 26% in a single year like it did in 2003.
  • Many equity index annuities also have “participation rates.” These can be in lieu of or in addition to a performance cap. If you have a participation rate of 55%, that means you get only 55% of the market’s rise. So, to use 2003 again as an example, you would have earned only 14% instead of 26%.
  • You will incur surrender charges if you try to withdraw the money prematurely. This of course is not an issue with buying individual stocks or most mutual funds. Most equity index annuities carry surrender charges of 5% or so.
  • You pay higher taxes for the gains on equity index annuities then you would from the lower, capital gains taxes on equities for mutual funds.

Jack Marrion, a research consultant for the insurance industry, has calculated the average equity index annuity return over the past five years to be approximately 5.6%. In other words, this investment — which is often referred to as a safe way to own stock — delivers bond like returns.

If you are a long-term investor and you need investment with the potential for greater return to complement your low-risk assets, equity indexed annuities are a poor choice. The better way is to determine how much money you can afford to invest and leave in the stock market, and invest that in the stock market either through buying a diversified portfolio of stocks or mutual funds that make sense for your needs. If you need to set aside a portion of your portfolio as a safety net, invest that in lower-risk assets.

Experts point out to this simple strategy, which will approximate the safety of an equity index annuity with not nearly as much in fees and no surrender charges. If you have $100,000 to invest but you know that 10 years from now you will need every penny of that, you can still participate in the stock market and protect your downside. You could, for example, buy approximately $70,000 in zero – coupon Treasury bonds. Ten years from now, you will get $100,000 from this investment. In the meantime, if you invest the remaining $30,000 in a S&P 500-index fund or some other diversified equity investment, you will still get the benefit of any upside in the stock market. Even if the stock portion of your portfolio falls 10% over that 10 years, your overall portfolio will still have gained three percent per year.

So the bottom line is, don’t let the recent declines of the stock market persuade you to buy an equity index annuity. These continue to be a terrible investment alternative for almost any investor.

Page Perry represents investors who have bought EIAs based upon bad advice from their investment adviser or insurance agent.

Page Perry, LLC is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. In the past eighteen months, the firm has won arbitration award for clients in the amounts of $1.7 and $3.9 million. For further information, please contact