For the record, I was told by some colleagues that I was awfully nice in my last newsletter to the companies selling Variable Annuities. For the record, I do not recommend Variable Annuities and selling VAs inside IRAs (or other tax deferred accounts) should be a felony...Now there:-)

What are Equity Index Annuities?

Equity Indexed Annuities (EIAs) are complex products sold by insurance companies that guarantee a minimum return if the contract is held to maturity and could pay buyers part of the capital appreciation in a stock index (usually the S&P 500 Index). An EIA is actually a cross between a fixed annuity because of the guaranteed rate and a variable annuity because of the potential for excess interest based on the peformance of a stock index. The basic idea is good (as it is for regular Variable Annuities) but in the real wold such products usually are complicated, very expensive and inflexible.

How EIAs are regulated?

EIAs are considered insurance products and are regulated by state insurance commissioners. They are NOT considered securities to have the added protections of being regulated by the SEC or NASD. Efforts to have the SEC step in here have been stalled by the powerful insurance lobby as usual. At the very least, with SEC oversight, it would provide another layer of regulatory scrutiny and possibly lead to getting more information about fees and features to consumers. Right now, these insurance companies do NOT publish expense ratios. One thing is for certain: Salespersons selling EIAs can make fat commissions - as high as 10% or 12% or sometimes up to 16%! -, much larger than selling regular variable annuities or loaded mutual funds.

Now let's look at some of their main features:

Guaranteed Minimum Rates of Return

EIAs guarantee a minimum rate of return - usually 3% - but this rate is usually much lower than the risk free rate of return offered on US Treasury securities of the same maturity duration. In addition, this guaranteed rate of return is usually not applied to the whole amount invested but a fraction of it and, sometimes, you get no interest credited at all if you do not hold the annuity to maturity.

Stock Index and Participation Rate

Most EIAs are linked to the S&P 500 Index. The changes in the index are taken into account but involve only price appreciation and do NOT include dividends. The exclusion of dividends tends to significantly underestimate the returns earned by S&P 500 investors.

In addition, EIA buyers do not get the whole price appreciation but a fraction of it, called the "Participation Rate". These participation rates can vary widely but where it really gets confusing is the way that each EIA can use different indexing methods to translate index level changes into returns on the contract. Two of the most common methods include "point-to-point" (with several different intervals used) and the monthly average return method. There is not enough space here to explain this in detail; suffice it to say that you can not easily back test the performance of an EIA to see if you came close to what you thought you would earn when you bought the darn thing!

Surrender Charges

EIAs have surrender charges up to 10% or 12% and sometimes even higher! These surrender charges usually decline as each year passes but can last for many years. The effect is that EIA buyers feel locked in and if they liquidate in the early years they are guaranteed to lose money.

Spread and Caps

Many people who buy EIAs think that they have downside protection AND fully participate in the S&P 500 index rise. I showed above how that is misleading due to the index change not taking into account the dividends and further being limited to the stated participation rate on the contract. That's not all. The return on EIAs can be further reduced by an amount called a "spread" which can be as high as 3%.

We are not finished yet. Lastly, EIAs usually have a "cap" on the index level changes. For example, let's assume that the cap on the increase in the contract index level change was set at 14% (probably buried on page 129 paragraph 2, third sentence from the end, of the contract). That year the index returned 19% but all the EIA buyer gets is 14%. The effect of this can be dramatic since the average long term return on stocks is heavily influenced by years with unusually high returns.

Taxes and Inflation

The returns earned on EIAs are taxed at ordinary income tax rates (as high as 35%) when they are eventually withdrawn. On the contrary, long term capital gains and dividends earned are taxed at a maximum rate of 15%. In addition, it is true that you get your money back at the maturity of the contract but it is an illusion because, in the meantime, inflation has really shrunk the purchasing power of these funds.

Conclusion

EIAs have a huge emotional appeal for unsophisticated and very conservative investors with their downside protection and upside potential together in one package. Unfortunately, similar or better results can be easily achieved by a combination of some zero-coupon bonds and a low cost S&P 500 index fund or Exchange Traded Fund (ETF) without sending yet another EIA salesperson to an all expenses paid trip to Jamaica as a prize for selling a bunch of them.

I will leave you with the conclusion by Craig McCann, PhD and Dengpan Luo, Phd in their paper "An Overview of Equity Index Annuities":

"EIAs are complicated investments sold to unsophisticated investors without the regulatory safeguards afforded to purchasers of similar investments. If brokers and agents told investors of the effect EIAs' shaving of index returns and extraordinary costs the market for these products would dry up…The net result of equity-index annuities' complex formulas and hidden costs is that they survive as the most confiscatory investments sold to retail investors".

• Article Link


If you ever needed to find out what Long Term Care costs around the nation, this link from Genworth can help. Beware, the company is in the business of selling Long Term Care Insurance and the coflicts of interest are obvious. But colleagues have found the cost numbers fairly reliable:

2007 Cost of Care Survey


• Quote


"Diversification is the price we pay for not making a killing in exchange for not getting killed" by Anonymous (if you know who said this please let me know, thanks)


• Quote


"Never think you know more than the market. Nobody does" by John Bogle, founder & former CEO of Vanguard


• Funny Acronyms


CEO = Chief Embezzlement Officer

momentum investing = the art of buying high & selling low

value investing = the art of buying low & selling lower

securities analyst = the idiot who downgraded my stock

stock split = when your ex-wife & her lawyer split your assets equally between them

bull market = a random market movement causing an investor to mistake him/her as a genius

ebitda = earnings before investigation, termination, deposition and arrest


• Article Link


Here is an article on how to give your brain some exercise:

15 Extra Ways to Keep your Brain In Shape


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"Old is when you have more memories than dreams" by Anonymous