A few years ago, we had a lot of cases involving an investment disguised and regulated as an insurance product: the “equity indexed annuity,” or EIA. We don’t hear much these days about equity indexed annuities. Why? Because the product was so justly maligned that the insurance industry decided to re-brand it to make it sound more warm and fuzzy. Today, equity indexed annuities are called “fixed income annuities” or “fixed index annuities.” Issuers slapped the word “fixed” on them to falsely insinuate that FIAs are a “can’t-lose” proposition. We, however, tend to agree with investment advisor and RIABiz contributor Ron Rhoades, who (in a column we highly recommend – http://goo.gl/lZhjM ) likened the name to putting lipstick on a pig.
So, what is an FIA? An FIA is an annuity tied to a stock index. It purportedly provides the opportunity to earn better returns than those in a traditional fixed annuity, though lesser returns than those from a direct investment in the market itself. The insurance company invests in a mix of bonds and stock options designed to give a targeted “participation rate” on the return of a particular index (for example, the S&P 500 Index). In other words, the purchaser is able to participate to some degree in stock market gains during a rising market. If stocks fall, the contract guarantees a minimum return, typically 3%.
In theory, FIAs are investment products that produce only positive returns. But in execution, FIAs often fall short of that result. FIAs are so complicated, and their prospectuses so opaque, complex, and riddled with definitions, cross-references, and crucial omissions, that even agents and advisors who sell them don’t understand how they work. You, the customer, could have no hope of understanding what you were buying, even if you attempted to absorb the issuer’s indecipherable disclosures. Thus, what a customer understands about FIAs generally is limited to what the advisor chooses to emphasize.
In a typical sales pitch, an advisor will characterize an FIA as a perfect investment for people who want tax-deferred growth with no downside market risk. But many advisors won’t tell you stuff like this:
- Even though FIAs guarantee a minimum rate of return, the purchaser can still lose money unless numerous conditions are met, among them, holding the FIA for a decade or more and agreeing to annuitize (i.e., to irrevocably tranfer ownership of invested funds to the insurance company.)
- FIA issuers impose costly surrender charges and fees to recoup their upfront payment of incredibly high commissions to your advisor or agent (who likely won’t mention such commissions when recommending the product.)
- The FIA return doesn’t include dividends (which you would have received had you invested in an index fund tied to that index), your return is capped at just a portion of the index’s uptick (with that portion susceptible to being reduced even more at the future whim of the issuer), and your return will be further eroded by a host of administrative charges (which also can be increased by the issuer.)
- Funds you invest in an FIA aren’t protected if the insurer goes belly up.
- Your withdrawn gains from an FIA will be taxed at ordinary income tax rates, rather than the lower capital gains rates that would have applied had you invested in an index fund tied to the same index as the annuity.
- Since annuities don’t receive any stepped-up basis upon the death of the owner, your heirs might incur a tax hit they wouldn’t suffer had you instead owned mutual funds held in taxable accounts.
- If you’re replacing an existing annuity or life insurance policy with a fixed indexed annuity, the death benefit promised under the replaced annuity or policy will be gone, you’ll incur new sales charges, and you’ll be whacked with a new surrender fee period.
If you’ve purchased any indexed annuity and have suffered losses, or if you think your advisor failed to tell you everything you needed to know before you bought it, we’ll review your account without cost or obligation and tell you whether we can help you recover all or some of your money.
Hugh Berkson is a Securities Attorney with McCarthy, Lebit, Crystal & Liffman, Co. LPA. Hugh is rated AV® Preeminent™ by Martindale-Hubbell®.
He obtained a business degree in Finance from the University of Texas at Austin in 1989, and is a 1994 graduate of Case Western Reserve University School of Law, where he was a member of the Order of the Barristers and received both the American Jurisprudence Award, (National Mock Trial) in 1993 and the Jonathan M. Ault Mock Trial Prize for 1993-1994.