Investment Tricks - Annuity Style

Last Updated Sep 10, 2010 12:37 PM EDT

Of all financial instruments I've seen over the years, the Equity Indexed Annuity has the most misleading information. The illusion created to sell them is the possibility of achieving stock market returns without risk. Here is one such pitch, worded to get you excited enough to wonder why your account isn't growing like you thought it was.

The "You Can Have It All" annuity pays you 100% of the average return of the S&P 500 index every year!
To see how this plays out in the real world, let's assume the S&P 500 total return is 12%. And let's say you actually read the part where the insurance company noted it was taking a two percent spread. What do you think your return will be?
  • a) 10 percent
  • b) 8 percent
  • c) 5.4 percent
  • d) 3.4 percent
Trick #1 - Strip out the dividends
The language in the sales pitch specified the "S&P 500 index" rather than the total return of the S&P 500. Total market returns come from two sources - capital appreciation and dividends. The index return is only the part that comes from the appreciation. Dividends, averaging about two percent annually, have been conveniently stripped out. So before the spread is deducted, your 12 percent return has already been cut to 10 percent.

Trick #2 - "average annual" return
If you actually possess the attention span to slog through the 373 page disclosure document, you would clearly see on page 189 that the term "average annual return" is defined as 1/12 of the first month plus 1/12 of the second month, etc. This translates to getting an expected tad over half the total annual return. Depending on the timing of the market increase, this could be either more or less than half. In this example, it yields about 54% of the total increase of the index.

Thus, the 10 percentage point index return turns into only 5.4% for you, as illustrated in the chart below.

Two Tricks and a Spread
So, after taking into account the stripped dividends, and the tricky language to take back nearly half of the rest, your return is 5.4 percentage points less the two percentage point spread. That's right, you net 3.4 percentage points, or only slightly more than a quarter of the market return. The correct answer was (d). This is far less than what you'd get if you built the functional equivalent of this annuity with a CD and a low cost index fund yourself.

It gets worse
If I haven't depressed you enough, nearly every EIA contract I've reviewed gives the insurance company the unilateral right to change the spread and the cap you can earn going forward. In short, the game is rigged. And this is merely one provision an insurance company uses in its sales literature. The industry has many other tactics I wish were illegal.

My Advice
The Equity Indexed Annuity is the ultimate behavioral sale on the planet. Earning market returns without risk plays to our human instincts of fear and greed. If it were real, however, I wouldn't be writing about it - I'd be rich.

Postscript: just posted a great piece on the return of this annuity in 2009, a year where the total return of the S&P 500 was 26.5%.

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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.