Beware of Index-Based Annuities
By Bob Moeller
WEAC Member Benefits
February 2006
Financial
Planning Seminars
Achieving
Financial Independence
I have been getting questions regarding index-based annuities and although I wrote about these several months ago, it may be time for another look. Under the typical equity index annuity, or equity-linked CD, the basic premise is:
- You cannot lose money and
- If a stock market index goes up, you may get the gain.
Unfortunately, little is said about the negatives. You must leave your money in for many years. If you cancel too early, you can indeed lose money. You will not get all of the stock market increase, only some. Or, maybe only a little. The expenses are very high in these products.
In short, I do not recommend this type of investment, great as it might sound. Unfortunately there are so many different twists on the product that it is impossible to make a general analysis that will apply to all of them. So let's look at one that even I, at first, thought sounded good.
This is a CD offered by Standard Federal Bank through a brokerage house. The term is 7? years. It is non-callable by the bank for two years. After two years, the bank can call it in, but must pay you 7% (simple, not compounded) per year.
So, if they call it in the third year, you get 114% of what you put in; fourth year you get 121%; fifth year 128%; sixth year 135%; seventh year 142%; eighth year (half year) 149%.
If not called, you get 100% of the growth in the S&P 500 index over the 7? year period (100% participation). You can't lose money if you hold it for 7? years, and, if you want, you can redeem it each three months after one year.
Sounds pretty good! Except for one detail. The bank can call it in. That means that if the stock market does better than the call in percentages, the bank will call it in. For example, in the fifth year, the stock market goes up a lot and the bank sees that you would actually get back more than 128% of your investment if you redeem it. They call it in, give you 128%, and it's over. True, if you beat them to the punch you might do better. But most likely they'll call it in if they anticipate you might use your next quarterly redemption privilege.
But still, 7% a year is not bad, right? Over a 7? year period, growth to 149% is about 5.6% a year. Well, even 5.6% is not bad right? Ah but you only get that if the stock market does real well. Anything less than that and you get whatever the market does, which could be 3% per year or 0%. Granted, you will not lose money.
Final summary: Under ideal stock market conditions, you will earn 5.6% per year compared to perhaps 5% you could get guaranteed with a regular CD. That's the best you can do. Quite likely you will do worse.
My advice? Don't do it.
Generally, insurance company deals will be even more complex with high fees and severe early withdrawal penalties. Forget the quarterly right to call it off after one year.
Speaking of guarantees, in terms of regular after-tax annuities, you might be told something like, "Our annuity pays a guaranteed 7% per year for 10 years!" (ING)
Sounds good doesn't it? I offered seriously to buy one myself so long as it was assured that at the end of the 10 years I could take out my money and the 7% interest I earned each year with no penalties. Whoops! A very nice agent finally acknowledged that it didn't quite work that way. The only way I would actually "get" the 7% per year was to annuitize the sum over my lifetime, or at least over another 10 years with a "10-year certain" annuity. And what interest rate would I get that second 10 years? ... 2.65%.
So, I have 10 years at 7% and 10 years with 2.6%. Works out to be about an average of 4.8% a year. Should I tie my money up for 20 years at 4.8% per year? I think not.
Let's close the argument against index annuity products with a quote from Rebekah Barsch, vice president of investment products at Northwest-ern Mutual Insurance. "The commissions are extreme. The surrender periods are too long. The complexity is way too high" (Wall Street Journal 12/14/05). To their credit, many big insurers won't even sell equity index annuities. You shouldn't buy them, or equity index CDs.
Posted March 8, 2006