Equity-Indexed Annuities Appeal to the Squeamish
At first glance, it seems like a case of extremely bad timing.
Tom Gochenour invested the bulk of his inheritance in the stock market Sept. 1, then stock prices plunged after the Sept. 11 terrorist attacks. But the value of Gochenour’s inheritance didn’t fall at all. The key: a little-known investment product called an equity-indexed annuity.
“An equity-indexed annuity provides a means to participate in the market with no downside risk,” said Tom McNeily, owner of McNeily & Associates, an insurance brokerage in Hinsdale, Ill. “I’ve become really sold on them in the last few years.”
Equity-indexed annuities are a complicated hybrid product and aren’t for everyone, McNeily said. People who can handle market volatility are likely to earn more in the long run by investing directly in the market--through stock mutual funds, for instance.
But indexed annuities provide an option--albeit a lower-yielding one--for those who can’t stomach a loss in their savings.
“I am 52 years old and this is my retirement money,” said Gochenour, a pharmacist who lives in Chicago. “I sleep a lot easier knowing that the principal is protected.”
Like all annuities, equity-indexed annuities combine insurance with an investment component. In this case, the insurance element provides a simple guarantee: You can’t lose principal, and in some cases, you can’t lose past years’ investment returns, either.
The returns on these annuities are loosely tied to a stock market index--most commonly the Standard & Poor’s 500. However, the investor does not get the full return of the index.
Depending on the annuity selected, the investor will get either a portion of what the index gained--40% to 90% of the rise in the index--or they might get a return that’s based on the percentage gain in the index, minus a margin. (In other words, if the index rose 12%, investors might earn 9%, or the index minus a three-percentage-point margin.)
In return for giving up some of the investment potential of the index itself, the investor gets a guarantee that the worst his investments can do over a specified period is earn a zero return.
The viability of these products lies in the details, said Jack Marrion, founder of the Advantage Group, a St. Louis insurance research and consulting firm. Some index annuities are a great deal for investors; others provide substandard returns.
The average annual return of these investments has been about 8.7% over the last five years, Marrion said. The S&P; 500, the most commonly used stock market index, returned almost 11% a year over the same period.
But the gulf between annuities, with the best returns versus the worst returns, is wide. In 1997, when the S&P; 500 rose 31%, the best-returning annuity paid 38%, he said, and the worst paid a mere 6%.
(It’s worth noting that not all annuities are tied to the S&P.; Many allow investors to put some money into several indexes at once--for instance a small-cap index, the S&P; and a fixed-income fund. Marrion’s figures represent the best and worst the various options could do.)
When the market soured in 2000 and the S&P; 500 fell 9%, a handful of index annuities paid as much as 12%, while many paid nothing.
To tell good index annuities from bad, experts suggest that investors look for a few key elements:
*
The Guarantee
The insurance component of equity-indexed annuities guarantees that the investor won’t lose principal. But does it also insure against losing investment returns accumulated over the years?
The answer depends on the annuity, Marrion said. Some annuities reset the principal value each year. Consequently, the amount of principal that’s protected rises every year that the investment produces a gain.
However, another type of equity-indexed annuity uses a “point-to-point” formula, which resets the principal value every few years. The exact number of years can vary. There can be a three-year, five-year or even 10-year gap between reset points.
Because the insurance company is taking somewhat less risk by making fewer guarantees with “point-to-point” annuities, they sometimes are more generous when formulating an investor’s return.
However, it also means that several years’ worth of investment returns could be wiped out in a bad year.
*
Investment Return
Some companies have a formula that never changes to determine investor returns. These companies may say, for instance, that the investor will always get 60% of the rise in the index to which the annuity is tied.
That would mean that if the S&P; 500 index gained 20%, the investor would get a 12% return. (That’s the 20% gain times 0.60.) If the index gained 40%, the investor would get 24%.
But many index annuity contracts allow the insurer to change the return formula, often called the “participation rate,” each year. With these variable-formula annuities, the investor could get 60% of the index return one year and 70%--or 40%--the next.
Annual changes aren’t necessarily bad--if they go in the right direction, Marrion noted. But companies sometimes start with a generous investment formula and make it stingier each year. Because there are often penalties for cashing out of annuities early, it’s tough for an investor to flee.
It’s worth noting that although other types of annuities have visible fees, the fees on an indexed annuity are folded into the “margin” or “participation rate.”
In other words, if the annuity company is giving you the index minus three percentage points, that includes the insurer’s profit margin. If the insurer boosts the margin or cuts the investor’s participation rate, they are effectively boosting the participant’s fees and consequently reducing the investor’s return.
If the annuity allows annual changes, there’s no way to know how the insurer will treat the investor in the future.
However, some companies that have been offering these products for several years have established records, Marrion said. Those that have treated their policyholders the best over the years are on an “honor roll” on Marrion’s Web site at www.indexannuity.org.
*
Surrender Fees
Annuities typically impose an exit fee on anyone who tries to cash out early. On equity-indexed annuities, these surrender fees are often high--10% or more--and long-term. Some products charge surrender fees to anyone who cashes out within the first five years, while other products have surrender fees that linger for more than a decade.
Surrender fees are levied for two main reasons: To pay the insurance agent a commission and to deter the investor from trading.
Investors should carefully match their goals with the duration of the surrender fee, Marrion said.
In other words, if you need cash from the annuity within five years, find an annuity with surrender fees that expire before that point--or policies that won’t penalize you for taking the money you’ll need. (Many annuities allow investors to withdraw up to 10% a year without surrender fees.)
Naturally, all other things being equal, the best surrender fees are small and of short duration.
*
Options
Equity-indexed annuities sometimes come with attractive bells and whistles. Some, for instance, allow investors to switch among different investment options--perhaps an S&P; index, a small-company stock index and a fixed-income fund that isn’t tied to stock returns--at regular intervals.
The ability to switch to a fixed-income fund is one reason some investors in these annuities earned generous returns even when the stock market was tanking.
Marrion believes it’s a valuable option that investors should seek when choosing an equity-indexed annuity.
*
Rising Popularity
Sales of indexed annuities rose sharply in recent years as risk-averse investors sought protection from volatile markets.
Sales of
Indexed
Annuities
Year (billions)
1995 $0.40
1996 $1.50
1997 $3.02
1998 $4.13
1999 $5.17
2000 $5.37
2001 $6.00*
*estimate
Source: The Advantage Group
*
Times staff writer Kathy M. Kristof, author of “Investing 101” (Bloomberg Press, 2000), welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof@latimes.com. For past Personal Finance columns visit The Times’ Web site at www.latimes.com/perfin.
