Could An Annuity Be Hurting Your Retirement Goals?

October 11, 2016 | by James Behr Jr & Christopher Paleologus

We have written a lot about what we like to invest in for our clients and what we think investors should be doing to prepare for retirement. Over the course of the next few weeks we will be discussing investments that we feel almost every investor can ignore and avoid with complete confidence. These investments, if not avoided, can completely derail the most prudent long term investment plans.

At some point you may receive a lovely card in the mail requesting your presence at an upscale steakhouse to listen about how to “grow and preserve your principal investment with no risk.” While this dinner may be free, if you do not know all the facts, it could end up being the costliest dinner you will ever attend. Specifically here, we will discuss Equity-Indexed Annuities (EIAs), which give the illusion of principal protection and investment growth.

An EIA is an investment contract with an insurance company, traditionally used for retirement purposes. The investor receives periodic payments from the insurance company as returns on the investment of premiums paid. EIAs offer a minimum guaranteed interest rate combined with an interest rate linked to an index. This can be very misleading to most investors as the calculations of returns and costs are not as straightforward as they might seem.

The first thing to know is how your return will be calculated. EIAs usually have a minimum return between 1-3% paid on a certain percentage of your premiums and the other portion will be linked to the specific index stated in your contract. This is where things start to get really foggy. With most EIAs there are caps that can limit your returns. This means that over the given time period used to calculate the return, if the index is up more than that cap, you will not participate in those gains. For example, your index annuity has a 3% cap, if the index was up 10% you will receive only 3%. Most annuities have these caps and yes, many are really that low. Moreover, most indexed annuities use a participation rate as well. This is the percentage of the index’s return that you will actually participate in. For example, if your annuity has a 70% participation rate, and the index is up 10% your return would only be 7% which is still subject to the cap. If your EIA does not use a participation rate they may use what is known as a spread fee. This is just a percentage that can be subtracted from the gain of the index. If the index was up 10% and the spread fee was 4% your gain would simply be 6%, again also limited to the caps. You will want to be sure to understand how your interest will be calculated. Some EIAs pay simple interest during the term of the annuity resulting in drastically lower returns.

The next thing to consider is how your index return will be calculated. There are three main methods to calculating your index return. The first is Annual Reset Method. This is just the change in the index from the beginning of the year to the end of the year. The second method is the Point-to-Point Method. This method calculates the index return from two predetermined points in time, such as the beginning and ending dates of the contract term. The final method is the High Water Mark Method. This method usually takes multiple dates, usually the annual anniversary dates, and calculates the return from the beginning of the term to the high index value of any of those dates.

After reviewing how your returns will be calculated, make sure to understand all of the other components of the EIA. Some EIAs allow the insurance company to change the participation rate, spread fees, or cap rates, so you will want to be sure what your EIA allows. Many EIAs offer bonuses as a percentage of premiums invested. Be careful. Problems arise because usually the bonuses do not actually vest right away but rather over a longer period of time, and if the contract is surrendered the bonus is lost. Furthermore, if you actually wanted to surrender the annuity you would be liable for large surrender charges and a tax penalty of 10% if you are under 59½, forcing investors to lock their money away for 10 years or more. Add on any riders, which are basically extra features investors can be sold, and the expenses associated with these annuities could end up costing investors a lot of money over the long run. A final point to remember is the elimination of dividends. Because you are investing in a product that only uses the prices of the index, you will be missing any dividends you would earn if you invested directly into the index yourself.

EIAs are complicated products so be sure to always understand exactly what you are buying and if you are unsure please review your annuity with us or another advisor with a fiduciary duty to act in your best interest. Remember that EIAs are regulated as insurance products so they are not subject to the same disclosure and rule requirements as other industries.