Equity Indexed Annuity Alert
Equity indexed annuities are relatively new annuity products as compared
to traditional fixed and variable annuities, but represent one of the fastest
growing segments of the insurance industry today. As their popularity grows,
equity indexed annuities are coming under increased scrutiny by regulators.
One reason for the widespread interest in equity indexed annuities is that
these products are often touted as a vehicle for investors to realize
stock-market-like gains without the risk, a “best of both worlds” marketing
strategy that has proven appealing to risk-averse seniors. However, the
expectation of a return that mirrors that of a stock market index is
unrealistic with equity indexed annuities.
The lure of a “guaranteed minimum” interest rate is an attractive feature to
investors who fear losing principal. Yet even with a so-called “guarantee,”
investors may still lose money buying an equity indexed annuity if the
guarantee is based on an amount less than the amount of premium or initial
payment. Investors needing to cancel an annuity to access funds prior to
maturity of the contract may also lose principal through surrender charges.
In reality, equity indexed deferred annuities are extremely complex
investment products and can contain many detrimental features such as hidden
penalties, costs fees, and massive, multi-year surrender charges. Despite
their complex nature, equity indexed annuities are typically not considered
securities and are not required to be registered with the SEC, as is the
case with variable annuity products. This means that most equity indexed
annuities are not required by law to have an accompanying prospectus with
disclosures regarding risk. And, unlike the sale of variable annuity
products, which require an agent to possess both an insurance license and a
securities license to be able to sell such products, equity indexed
annuities may be sold by life insurance agents who have taken and passed a
40-hour licensing course and state life insurance exam.
Before investing in any deferred annuity, investors should have an
understanding of the true terms and conditions and any potential
financial consequences associated with that purchase. A prospective
investor should understand: (1) the overall product features of that
annuity; (2) the tax impact that annuity may have for the investor and
beneficiaries; (3) the projected rates of return and the certainty of
those rates; (4) the liquidity of the investment; (5) the age the
annuitant must reach before being eligible to receive regular
annuitization payments without penalty; and (6) all of the fees and
costs associated with that product.
An equity indexed annuity is distinctive in that there are several unique
factors which may affect potential return, and an investor should understand
how these factors will influence his or her investment. The unique features
used to calculate the interest an investor may receive typically include:
- Interest Rate Caps: With an equity indexed annuity, you shouldn’t assume
that you will be receiving a return on your investment that’s comparable to the
return achieved by the underlying index. Frequently, equity indexed annuities
set a maximum rate of interest that an investor will receive, even if the
underlying stock market index performs well. For example, if an equity indexed
annuity has a “cap,” or upper limit of 6%, and the underlying index earns 20%,
the maximum the investor will be eligible to receive is still only 6%.
- Participation Rates: Even when the underlying index earns a return of
20%, the interest credited to the equity indexed annuity may not be calculated
based on that 20% return. The term “participation rate” is used to describe how
much of the increase or return of the underlying stock market index will be used
to calculate the return. For example, if a participation rate is 70%, and the
index increases 20%, the return credited to the equity indexed annuity would be
only 14% (20% x 70% = 14%).
- Index Crediting Methods: In some cases, investors may be able to choose
the method by which interest will be credited to equity indexed annuities.
Common methods of interest calculation include “high water mark,” annual
ratchet, and one or two year point-to-point averaging. With each of these
methods, interest is calculated based on specific points in time. For instance,
an annual ratchet method usually credits an amount of interest based on any
increase in value of the underlying index from the beginning to the end of the
year. A point-to-point crediting method, on the other hand, credits an amount of
interest based on any increase in the value of the underlying index from the
beginning to the end of specific term, which may be based on the contract date.
Fees and Charges
In addition to the above factors that may affect potential return in equity
indexed annuities, deferred annuities usually also carry associated fees and
charges that may greatly restrict an investor’s ability to access funds, and may
serve to penalize investors who need to access funds during the life of the
contract. Unfortunately, many investors are unaware of such costs until its too
late. Because of this, it is especially important to get clarification of all
potential fees and costs before investing in any equity indexed annuity product.
Some of the common fees and charges associated with equity indexed annuities
include:
- Surrender Charges: Surrender charges may vary dramatically among
annuities, and can be as high as 25% and last as long as 20 years. While most
deferred annuities carry surrender charges, some equity indexed annuities carry
surrender charges that are higher, and last for periods longer than traditional
fixed or variable annuity products. Funds withdrawn from an annuity prior to the
expiration of the contract’s surrender charge period may be subject to hefty
surrender fees.
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Administrative Fees or Margins: Some equity indexed annuities contain an
administrative “fee” that amounts to the difference between the percentage gain
in the index and the actual amount credited to the investor. The difference,
which may also be called a “spread” or “margin,” is retained as an asset fee or
administrative charge by the company. For example, in the case of an annuity
having a “spread” of 15%, when the index gains 20%, the return credited to the
annuity would be only 5%, and the company would keep the 15% spread as a fee.
These fees are not always disclosed clearly in marketing materials or in
contracts, but may be “implied” based on index crediting methods.
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Market Value Adjustments: Some annuities, and especially equity indexed
annuities, include a feature known as a “market value adjustment.” This may be a
complex formula that is difficult to understand, but market value adjustments
typically function to alter or reduce the cash value of an annuity dependent on
changes in the interest rate since the contract’s issue. Such adjustments may
result in a partial or full loss of any previously credited bonuses or interest
credits, and potentially, may also result in loss of premium during the
surrender charge years of a contract.
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Asset Fees: These fees may be charged by the company, and based upon
a percentage of the value of your annuity. Asset fees could be subject to
change annually. Always ask for a written disclosure of all fees of any type
before signing on the dotted line.
Investors should know that investing in an equity indexed annuity can differ
significantly from investing directly in a stock market index. For example,
dividends may be excluded and the gains may be treated as ordinary income at
rates as high as 35%, rather than as capital gains. Consult your tax
professional for details regarding equity indexed annuity tax consequences
for both you and your beneficiaries.
Equity indexed annuities are complicated products that are difficult to
understand. Uninformed consumers are often targeted by unscrupulous agents
employing deceptive sales practices, and equity indexed annuities have
become a prime vehicle for this kind of fraud. Deceptive sales practices can
occur in many different ways, and nearly anyone can become a victim. The
best weapon against fraud is knowledge. Know what questions to ask, and
watch out for red flags that could signal you’re being targeted for fraud:
- Bonus gimmicks. Beware of the promise of a “bonus” used to entice you
into investing in an equity indexed annuity. You may be told that a “bonus” is
designed to “make up” for surrender charges incurred in liquidating in force
investments and purchasing new annuities. However, bonuses are often illusory,
and are seldom paid up-front. It is not always in your best interest to
surrender an in-force annuity or life insurance contract to purchase another.
You may find that the fees and charges associated with the new policy, or the
surrender of an in-force policy, outweigh any benefit that a bonus may provide.
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Be wary of agents who are eager to pressure you into purchasing a deferred
annuity with a promise that you can use it to supplement your retirement income.
If you’re a senior and you’re seeking to supplement your retirement income, a
deferred annuity may not be the appropriate investment choice for you. Immediate annuities, on the other hand, may better serve seniors seeking to
supplement their income.
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Agents who tell you that an investment in an equity indexed annuity will give
you a stock-market-like return with no risk may not be telling you the whole
truth. It is possible to lose money in an equity indexed annuity, especially
if you have to cancel the contract prior to the expiration of the surrender
charge period. It is also possible to earn a zero percent return in an equity
indexed annuity.
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Get clarification as to what a “minimum guarantee” really means. For
instance, will you be guaranteed to receive a stated rate of return on the
entire amount of your principal, or only a portion of it? Will you lose the
interest that’s been credited to you if you surrender your contract or make a
withdrawal? For how long is the stated “minimum guaranteed rate” effective? Can
this rate be changed by the company at some point in the future? Make sure you
have written clarification on these issues before you buy.
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Ask whether the rates you’re promised during the first contract year will
remain the same for the life of your contract. The insurer may reserve the
right to reset or change the guaranteed minimum interest rate and the
participation rate yearly. Changes in either of these two variables may affect
your potential return.
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Ask your agent to perform a suitability analysis for you prior to any
recommendation. If you’re 65 or over, it’s the law. Agents are required
to perform such analysis prior to selling you any annuity. Get it in
writing.
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Think carefully before surrendering in force insurance or annuity products to
purchase new ones. It is seldom financially beneficial for investors to
surrender in force insurance or annuity products to purchase new ones. This is
especially true for seniors. In addition to financial penalties or other losses,
such moves may expose you to new surrender charge periods or other harmful
features.
Remember, an annuity is a long-term investment. Before you buy an
annuity, you should understand the various features of the investment and be
prepared to ask your insurance agent, broker, financial planner, or other
financial professional questions about whether the annuity is right for you.
And finally, don’t hesitate to get a second opinion from a trusted and
qualified financial professional prior to making any annuity investment.
When considering the purchase of an equity-indexed annuity, investors should
consider the detrimental features along with the benefits, and a decision to
invest should only be made after being fully informed.
CFO Sink urges seniors to take the following precautions to avoid becoming a
victim of financial scams:
- Assess your financial means and investment objectives prior to
purchasing any investment.
- Don’t be swayed by free meals or other inducements.
- Ask the sales agent about the licenses and/or designations he or she
holds, and what types of investment choices he or she can offer you.
- Be cautious about special designations such as “senior advisor” and
ask about what designations actually mean. In many cases, such designations
require no specialized financial training.
- Don’t assume that every agent is always acting in your best interest.
Ask about commissions, fees, penalties, surrender charges, and any other
associated costs. Get the figures in writing prior to any sale.
- When considering the purchase of an equity indexed annuity, ask
your agent about applicable cap rates, participation rates, index crediting
methods, and all associated fees. Have your agent explain, in writing, how these
will affect your investment.
- Ask your tax professional about tax consequences of equity indexed
annuities, both for you during your lifetime, and for your beneficiaries.
- Always request a comparative analysis in writing between your
in-force investment and any new investment.
- Before you surrender any in force investment to purchase a new
product, call the company to find out if you will suffer a surrender charge, and
if so, how much it will be. You may discover that the cost of a transfer
outweighs any benefit of a new product.
- Beware of “bonus” interest rates, as they are usually limited in
duration and have strings attached.
- Be cautious of sales pitches that claim you will “recoup” all
penalties with the higher returns of a new policy.
- Ask questions and take notes. Walk away if an agent doesn’t answer
your questions.
- Don’t let your guard down simply because an agent is a member of the
same religious, ethnic, cultural, or professional group. Its human nature to
trust people with whom you have a common background, and religious or ethnic
identity is a common source for affinity fraud.
- Take your time. High pressure sales tactics will rush you into an
unwise decision. A sound investment will be just as good tomorrow or next week.
- Document all transactions.
- Never agree to make a check payable directly to an agent.
- Carefully read and understand all documents before you sign them.
Don’t sign any blank or incomplete forms. Fraud is commonly committed when
consumers are convinced to sign incomplete documents, only to discover that
terms were later inserted without their authorization. Signing blank or
incomplete forms is never in your best interest.
- Remember: if it sounds too good to be true, it probably is.
Click here for a general overview of other types of annuities and how to decide which may be right for you — and which to avoid.
Consumers who believe they have been victimized should call the Department's
Consumer Helpline.
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