Posted by: Robert Hutchinson
June 28, 2006
Topic: Equity Indexed Annuities

EQUITY INDEXED ANNUITIES: ARE THEY SUITABLE FOR ANYONE?

Complicated equity indexed annuities, unsuitable for most people, are being pushed on the public by the billions.

Equity indexed annuities made their debut in the US in 1995, and since that time their sales have grown dramatically, even though the customers' principal is not protected from downside risk, and their rates of return are as questionable as their virtually impossible to understand formulas used to calculate them. Last year about $25 billion of these were sold.

These annuities are similar to so-called equity participation securities ("EPS") which guarantee the investor a return of principal plus an increase of it reduced by an annual spread. Typically, when boiled down, an equity indexed annuity is nothing more than an EPS with a trivial insurance benefit tacked on, often accompanied by disadvantageous tax treatment, and exorbitant costs.

This formula is comparable to its kissing cousin, the variable annuity formula: A mutual fund plus a trivial insurance benefit and exorbitant costs.

The National Securities Dealers Association ("NASD") the securities industries own regulatory body has issued warnings about these. In August, 2005, the NASD issued its Equity-Indexed Annuities Notice to Members 05-50 warning that in order for these to be sold the sales people must first determine that these are suitable investments for their investors. Similarly, in June, 2005 the NASD issued its Equity-Indexed Annuities - A Complex Choice Investor Alert warning the public of their complex nature. So, in addition to sales people making a suitability determination, these two issuances require, among other things, that they understand the maze of hidden costs, the virtually indecipherable rates of return, its many complicated features, and can explain them thoroughly to the investor, something that few, if any, are really able to do.

The bottom line is that these complicated to the point that virtually few of the sales people or the consuming public understand what they do and don't offer. In other words, they can't be evaluated by most, and when that is the case, their suitability really can't be determined.

Typically an Equity Indexed Annuity ("EIA") pays out over a long period of time an amount pegged to what the stock market returns, and so the exact payout is unknown. Compare this to bonds, where the pay out is known exactly.

Like its cousin the Variable Annuity, EIA's usually have stiff surrender charges, with many are in the 10% -12% range, and some are even as high as 25%!

Sales people often tout the EIA's "guaranteed rate of return." But what about the principal? And is the return any good? First of all, these annuities do not guarantee that the investor will not lose money, but only guarantee a rate of return. Second, this guaranteed rate is something that is usually in the area of 3%. The problem is that return is lower than the return an investor can get buying US Treasury certificates with comparable maturities, and unlike US Treasury certificates, the principal is unprotected. In other words, the risk and reward ratio is out of whack.

Worse yet, the returns are usually pegged to an appreciation index of the Standard & Poor 500 - meaning that this amount does not take into account the reinvestment of dividends, which is often fully one-fifth of the S&P's total return.

Why are these things getting pushed on the public? The answer is revealed by the huge amounts of money involved. It has been estimated that somewhere in the area of 15% -20% of every premium dollar goes into the pocket of the insurance companies and their sales people. At the current estimated rate, this amounts to astronomical $3.75 billion to $5 billion dollars a year.

At the end of the day, who benefits? Is it the customer or is it the insurance company and its sales people? The question may be fairly asked: Are these things really suitable for anyone?

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