Bradley P. Halverson, CFA, CPA wrote an article today 20 June 2006 in MeridianMagazine.Com on Equity Indexed Annuities. If I understood him correctly he's not a big fan.
An Equity Indexed Annuity is often marketed as offering stock market returns without the downside risk. The return is linked to something like the S&P 500. It offers a guaranteed minimum return around 3%. HOWEVER, the devil is in the details. What you are really buying is an ordinary fixed annuity with several attached options.
The first option pays the minimum guarantee stated in the contract. The higher the minimum guarantee, the more it costs. The structure of the Equity Index Annuity hides this cost from you. You usually pay for the option with two other options. These options pay you a percentage of the upswing in the equity index and cap the maximum upside you can earn.
Mr. Halverson gave an example. His friend was offered a contract with the following terms:
- 3% minimum return on 90% of your money (by not covering 100% it lowers the cost of the option.)
- 70% of the upside of the S&P 500 above the index at the date of purchase.
- 12% maximum return.
If the S&P 500 is up 20%, you would only earn 12% because of the 12% cap.
If the S&P 500 is up 10%, you would only earn 7% because of the 70% participation.
If the S&P 500 is down 10%, you would earn 1.7% because you would earn 3% on 90% of your money (2.7%) and lose 10% on 10% of your money (1%).
So, what do you end up with? An investment with high up front costs, severely limited liquidity, designed to give an average return a couple of percent above the bank certificate of deposit rate over its life. This is a savings product, not an equity return investment. Granted, in a few specialized cases this may be a good fit. But for most people Equity Indexed Annuities should probably be avoided.
Instead, go get a currywurst at the World Cup tournament. It is thinly sliced sausage, with ketchup squirted on it and then sprinkled liberally with curry powder. Or, if you don't like curry or ketchup, buy a doner kebab. I first ran into these in Australia, but they are of Turkish origin. They are thinly sliced rotisserie meat with different dressings and toppings wrapped in a pita shell. Both are favorites of the World Cup fans. I can hear my stomach rumbling and I just ate. No wonder I look like an elephant in my photo in my bio. Bon appetite!
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