Investing Trends

Anyone who's been fishing knows that one of the keys to catching the big one is having the right kind of bait. Many in the financial services industry understand this truth all to well and they've come up with the perfect enticement to hook unsuspecting investors. It's called the equity-indexed annuity (EIA) and chances are, if you've visited a traditional advisor recently, you've heard its compelling pitch.

Of course, for bait to be effective, it has to be something the intended target will happily swallow. Insurance companies have created a wonderful presentation that uses smoke and mirrors to give investors the impression that equity-indexed annuities are the answer to all their financial problems. But the reality doesn't live up to the promises.

The marketers of financial products know that one thing older investors want is simplicity. Seniors don't want to have to wade through a lengthy sales pitch or be overwhelmed by financial techno-babble. Salespeople know if they can offer an apparently simple solution to investors, their chances of making the sale are greatly increased.

Equity-indexed annuities are presented as being a simple way to have risk-free growth of your nest egg. They promise a guaranteed minimum return, while keeping the growth potential of the market. They promise that you can't lose any money and many even sweeten the pot with first year bonuses and riders that allow you to access your money for nursing home care and other early withdrawals. It all sounds so good and it's so simple. But is it, really?

The answer is no. Equity-indexed annuities are actually very complicated.

Let's take a closer look at how complicated equity-indexed annuities really are by starting with their chief claim, the guaranteed minimum return. Most investors have the impression that on a year-to-year basis they receive the guaranteed minimum return or the market return, whichever is higher.

But that's not true. You either get the indexed return or guaranteed minimum return for the life of the contract, whichever is greater. So if it's a 15 year contract, at the end of the 15 years, the insurance company looks back and figures whether you'd have earned more, at the guaranteed rate or the market return for the entire 15 years. So suddenly the guaranteed minimum isn't too impressive.

To make matters more confusing, on some contracts you don't get the guaranteed minimum return on all of the money you put in. For instance, some pay a 3% guaranteed minimum return on just 80% of your initial investment. So in essence, you're really guaranteed only 2.4%. That doesn't sound as good, does it? When the list average on a short term Certificate of Deposit is around 5%, why would you want to lock in a 2.4% rate for 15 years?

How the index return is calculated is much more complicated. You'd think that the insurance company would just tie your market return to an established index, like the S&P 500, and mirror its return. Unfortunately, it's not that simple. There are over 40 different methods in which these rates are determined and they vary widely from company to company. The explanations for these calculations are so complex, there's no way the average consumer could even hope to understand them. Even professionals find these methods extremely confusing.

Even if you could understand how your index return is calculated, it doesn't matter because the insurance companies can change how they calculate it from year to year. They can also modify the maximums, minimums, participation rates, asset fees, other charges at their own discretion. And there's nothing you can do about it.

Why would insurance companies do this? That part is very simple. Insurance companies understand the importance of keeping their flexibility and control, because they know that the markets and interest rate environments can change dramatically over the life of your contract. They put these safety valves in place so they make sure they make a profit. Of course, that can reduce how much you make.

If insurance companies put a high priority on maintaining their flexibility and control, shouldn't you? Be smart and don't take the bait purveyors of equity-indexed annuities are offering. Use your head and don't get sucked into a deal that, like many others, you may soon live to regret.

Mr. Voudrie is a Certified Financial Planner, nationally syndicated newspaper columnist and President of Legacy Planning Group, Inc., a Private Wealth Management Firm in Johnson City, TN. He can be reached at jeff@guardingyourwealth.com