Insurance companies make money on fixed annuity products by investing the premiums and hopefully earning a higher rate than they pay out. The rate they pay out might be a fixed rate or it might be a rate tied to some sort of formula, a formula they control.
In my client's case, the formula appeared generous. My client would receive 100% of the appreciation of the market over each period she was invested. If the market goes down she loses nothing. Sound too good to be true? It is.
What is typically left out of the conversation or simply to complex to describe, is how the true return is watered down and apparently manipulated by the insurance company by accounting tricks.
A real life example is the portion of my client's account that was invested on April 21st, 2014. The S & P 500 Index was at 1,871.89 and the time period would be one year. The S & P 500 closed at 2,117.69 on 4/20/2015, an increase not including dividends of over 13% (with dividend probably 15%, I didn't run that calculation). By all accounts, a great year and one that even a bad equity indexed annuity (EIA) should have performed reasonably well. If an EIA can't have a decent return when the market is up over 13%, you are in big trouble...like my client. My client earned a total return for the period of 0.958%. You didn't read that wrong, it's less than 1%.
So what happened? Several things.
The first trick is that while the S & P 500 was used as the index and my client got to participate in it 100%, the index was "averaged". This means that instead of taking the value at the beginning and the value at the end (called point to point), the insurance company takes the value every day and divides by the number of days. This has the effect of cutting the ending value, sometimes in half. This can be advantageous if the market is volatile and ends down, but it also allows the insurance company to make you think you are getting a participation rate of 100% when in fact you are not.
My client didn't participate in ANY dividends and didn't even participate in the full 100% return of the market, the ending value with averaging was 2,020.88 or nearly 97 points lower (about 5%).
Ok, that's not bad...it's still up about 8% year over year, that's a fantastic return for a fixed income instrument and I would agree, except there is another trick at work here, the "spread".
Each year the insurance company can set a "spread" and that spread can be as high as the company allows it to be subject to a maximum set in their contract. My client's spread for this investment in this particular year was 7%.
The spread works very simply, you just subtract the spread from the overall return. If the ending (averaged) value was 10% higher than the beginning value, you minus your 7% and the credited rate is 3%.
7% is a VERY high spread, especially since the long term growth in the S & P 500 is NOT even 7% annually when dividends aren't reinvested. The insurance company is essentially making sure you don't earn a return.
My client's investment was credited with less than 1% when the market was up about 15%, does that sound like a good deal to you? Also, even though she's been in the account since 2005, her surrender charge is still over $11,000. What. A. Deal.
This is a scam and why insurance companies LOVE equity indexed annuities. They can manipulate many little levers to insure they never have to pay a rate that is very high. Not all EIA's work like the one I'm describing, but they all have the levers and you better know what they are and how they work and what the minimums and maximums are as well as the historical probabilities of...oh, forget it, just don't buy these junk products.
Lest you think I'm making this up, I have the statement and can prove it.
Bottomline - don't buy Equity Indexed Annuities.
Scott Dauenhauer, CFP, MPAS, AIF
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