That's one of the top five questions in my mail bag these days. Thousands of people attend free dinners and lunches every week to learn about the miracle investment that will give them near stock market returns without the trauma of market busts. The basic offer of an equity index contract is this:
- You give your money to an insurance company for a period of time, often 10 years, and it will grow tax deferred.
- In return, the insurance company promises to give you a return based on some proportion of the rise in a major stock market index, excluding dividends. How much of the index return you get varies from contract to contract because there many crediting formulas.
- It also promises a minimum rate of return, usually about 3 percent. And if the stock market tanks, the value of your account doesn't go down, so you get to sleep at night.
- If you take your money early, however, you will lose much, or all, of your return through take-backs and penalties.
But is it really that good?
That's not an easy question to answer. The contracts are so varied and so complicated it is next to impossible to benchmark them. One result is that sales people often make extravagant claims.
How extravagant? Enough that the National Association of Securities Dealers (NASD) declared, in 2005, that it was "concerned about the manner in which associated persons are marketing and selling unregistered EIAs, and the absence of adequate supervision of these sales practices."
My translation: "These things are being sold willy-nilly and are likely to become a big time source of expensive lawsuits for brokerage firms that sell them."
Unfortunately, that still doesn't tell us much about the actual investment. I grumbled about this to John R. Fahy, a former SEC enforcement attorney in Fort Worth. Mr. Fahy, who developed a dark and wry sense of humor at the SEC, now serves as legal counsel to investment firms. Not to worry, he said, a study of EIA performance had been done by two PhD's in financial economics from leading graduate schools, Craig McCann (UCLA) and Dengpan Luo (Yale).
The study, believe it or not, is very readable. It is also available, free, as a PDF download. If you're about to head for an event celebrating the cosmic benefits of equity-indexed annuities, I suggest you read this document first. If you like making people squirm, show a copy to your enthusiastic salesperson.
For those who can't wait, the study estimates that "between 15 percent and 20 percent of the premium paid by investors in equity-indexed annuities is a transfer of wealth from unsophisticated investors to insurance companies and their sales forces."
Benchmarking against a simple $100,000 portfolio consisting of 60 percent 10-year Treasury strips and a low cost S&P 500 index fund, the two researchers did a Monte Carlo analysis of probable returns. The simple portfolio beat the equity-indexed annuity a whopping 96.9 percent of the time.
Moreover, after ten years the expected benefit of the Equity Indexed Annuity was only $219 when it did better but the expected benefit from the simple portfolio was $33,650. Researchers McCann and Luo concluded that EIAs cost the investor about $153 for every $1 of possible benefits.
It's not a pretty picture.
If you're still looking for a way to think about this product, try this: An Equity-Indexed Annuity is the inverse of a hedge fund. The typical private hedge fund offers to take extreme risk in the pursuit of gain in exchange for 2 percent of principal and 20 percent of any gain. The typical Equity Index Annuity offers extreme safety in exchange for all dividends (about 1.7 percent a year for the S&P 500) and 50 percent of the capital appreciation.
Hedge funds are a lousy deal for the rich. Equity-indexed annuities are a lousy deal for the rest of us.
On the web:
The SEC explains equity-indexed annuities
NASD Notice to Members 05-50 on Equity-indexed annuities
An overview of Equity Indexed investments