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How Can Equity Indexed Annuities Make Such Grand Promises?

Seth Jentner04/11/2013

Earlier this week, I discussed if equity indexed annuities are a good investment. Because of their high fees, we don’t typically recommend them. Often, there are promises made that investors will participate in the upside of the stock market without taking the downside risk.

So how can these promises be made?

The annuities are usually backed by derivatives, which are investment contracts whose value is based on returns in the stock market. The insurance company guarantees an investor’s principal if held to its term, but that period can be as long as 10 years. Meanwhile, the return given to investors leaves out the dividends paid on stocks, which accounts for a large portion of long-term stock returns. Insurers are even allowed to impose caps on the annual returns of index annuities.

The result is a great sounding product that offers a great deal of perceived safety but with a very modest opportunity for upside return. Because the principle guarantee requires a relatively long-term hold, the investor accepts the risk of future inflation, which can reduce the purchasing power of the dollar.

Agents who sell indexed annuities receive commissions of up to 12 percent of the sale price. Investment News reported that one insurer was offering its agents free trips to Disney World for selling at least $2.5 million worth of annuities over 12 months.

It is important to remember there are only 100 cents in a dollar. If something sounds too good to be true, it generally is. These equity indexed annuities offer a safe place to deposit money, but because of the long-term contingent deferred sales charges, there is little opportunity for buyers to change their minds without suffering a loss of principle. This is not really an equity investment but a fixed-income investment with a great deal of illiquidity and inflation risk.

This is certainly a case of buyer beware.

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