Have you heard of equity-indexed annuities (EIAs)? They promote the dual benefits of a guaranteed, minimum return (limited downside) with market returns (upside potential) based on an equity index. On top of that, you can even defer taxes for years until you withdraw funds. For the highly risk-averse investor who doesn’t want to miss out on possible stock market gains, an equity-indexed annuity certainly sounds attractive.
However, there is no free lunch in investing, and that’s especially true with EIAs. These products require considerable research, and they are appropriate only for investors who don’t need to withdraw the money during the long life of the contract. They also require careful analysis of the risk of the issuer. And that tax break is great only until you withdraw from the annuity and pay ordinary income taxes on the gains, rather than the lower capital gains tax rates available on other investments.
Equity-Indexed Annuities (EIAs)
EIAs are contracts with insurance companies that are designed to give a low, fixed rate of return, plus the potential for higher growth if a designated stock market index rises. Like many things, the devil is in the details, so let’s look at some unique features of indexed annuities:
Equity Index. Typically, EIAs use Standard & Poor’s Composite Stock Price Index (S&P 500) as their index. This is a widely respected and useful index, but it lacks international diversification that a portfolio should contain. Furthermore, dividend payments from S&P 500 companies play an important role in the performance of the S&P 500 index, but these dividends might not be included in the calculation for crediting the return on the purchased annuity.Without dividends, EIAs often underperform the S&P 500 by one to three percentage points per year.
Rate of Participation. You’ll never receive the whole market index return with an EIA. For example, if the participation rate is 80% and the index gains 10%, then the interest rate on the index-linked annuity will be 10% multiplied by 0.8, or 8%. Read the fine print, because it might get worse: your participation rate might not be fixed for the term of the annuity. Find out how it will be adjusted.
Cap on Interest. Some EIA contracts put a ceiling or cap on the rate of return to an investor. For example, if the cap is 7.5%, then the holder of the annuity in the previous example will get credited with 7.5%, not the 8% indicated by the participation rate.
Minimum Rate of Return, or a “Floor” on Interest. Typically, the lowest rate that an EIA can earn is 0%.
Administrative Fee. Annuities normally have annual fees of 1.5- 3% (sometimes more), which further reduce the return paid to the investor at the end of the contract.
Are Equity-Linked Annuities Right for You?
In our experience, EIAs are rarely the best option for our clients. If you are thinking about buying one, consider these points:
- Can you lock up your funds for 10 years or so? Typically, there are hefty deferred sales charges and a loss of credited interest for accessing your principal prematurely. If you pull out of a contract early, you might get less than you invested.
- Are you comfortable with the trade-off of accepting potentially significant limits on an equity return, in exchange for downside protection?
- What other tax-advantaged choices are available to you? If you have not maxed out your IRAs, 401(k)s, etc., then you might want to use those strategies first.
- Gains in an annuity are taxed as ordinary income at your highest tax rate, not at the lower capital gains rate of other long-term investments.
- Annuity issuers usually pay concessions of 5-10% to the brokerage firms selling them, so beware of potential conflicts of interest.
Bottom Line: Do your homework, comparison-shop, and seek advice from a Fee-Only advisor before purchasing an annuity.