Equity Indexed Annuity

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.
• 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.
• 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.
• 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.
• 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.
• 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.
• 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.
• 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.
• 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.
• 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.

Seniors should 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.