On the right, you will notice a graph that represents how an equity indexed annuity works. But, if you type those words into Google ("equity indexed annuity" or "EIA"), or any search engine for that matter, you will find no shortage of words like "scam," "misleading," "deceptive," "waste of time," "waste of money," "...they can't possible deliver on their promises," and so on. Why the bad rap?

It's funny that in this business when you come up with and are able to sell a new and innovative product, you often get attacked on all sides by individuals who are entrenched in tradition. Many, if not most, of the attacks come from brokers, firms, or advisers that sell mutual funds. And...that has been a long-standing tradition in the financial services industry...sadly. The general sentiment is that the life and annuity folks hate the mutual fund folks and vis versa. It's like the Hatfield-McCoy feud. Each one "steals" business away from the other, and each side is willing to go to great lengths to convince the public that their secret sauce is the best.

But these products don't compete with mutual funds, do they? Well, no...sort of. Technically no. An annuity is just an insurance contract that promises a very specific payout at contract maturity. EIAs have their own set of special terms and language like "caps" and "participation rates" and "crediting strategies." There is a minimum guarantee in the product, usually 2% of the deposited savings compounded annually for the entire term of the contract

In all honesty, what you look for in these kinds of products is simplicity. In a previous article, I explained how equity indexing works - the mechanics and technical details. If you haven't read that, you might want to at some point. EIAs are built around a few basic ideas.

First, the underlying investments - the options. The price of the options (which give you the upside potential of the stock market) can heavily influence caps and participation rates on EIAs (more on that in a moment). When option contract prices go up...something must come down so that the insurance company can afford to pay its claims. Usually the easiest way to do this is to lower the interest that gets credited to the contract.

Second, the caps - this will partially determine how much you can earn. A cap is exactly what it sounds like: a cap on earnings. Insurance companies will offer the upside potential of the stock market up to a cap. The reason they do this is not because they are hatching an evil scheme to "rob" the client, but because they are taking all of the risk. They need to make a profit when they do well. 

Third, the participation rate will determine how much you can earn. A participation rate of 100% means you get 100% of the upside potential. When the stock market moves up 10%, you make 10%. 80% means you get only 80% of the upside movement and so on. For example, if the index moves up 12%, and you have an 80% participation rate in your contract then you are credited 9.6% up to the cap. If the cap is 7%, you are credited 7%.

By now you can see with those "moving parts" there is some potential for individuals to get into trouble with these products. When a few agents misrepresent the earning potential of the annuity they are selling, people get hurt financially. An injured client (soon to be former client) inevitably blows the whistle,  and the media frenzy ensues. Then, every financial guru with a personal grudge against insurance companies comes out  of their hole to write a dissertation about how evil and awful these products are.

The reality is that the product isn't bad at all. It's up to the adviser or insurance agent to honestly explain how the product works.

In the mutual fund world and in the insurance world, commissions are a real driving force. Sometimes agents and advisers are at odds with their clients because what's good for the client doesn't always pay well. If an agent isn't particularly adept at marketing, they may be desperate for a sale and sell the higher commission product (mutual fund, annuity, life insurance, etc.) and leave their client holding the bag so to speak. By the way, lower commissioned products tend to have higher caps and participation rates - good for you if you are buying into an EIA.

This is why I say "simplify, simplify, simplify"...or maybe that was Henry David Thoreau. Anyway, it's rather easy to gauge how good or bad an EIA is. The less moving parts, the better. If they guarantee 100% participation, that's an excellent start. If they pay the agent or adviser less than 6% commission, then they are usually shorter term contracts with higher caps and participation rates...it's not always the case, but it tends to be true.

To sum it up, it's all in the research. Every company does business a little bit differently, and therefore everyone's product operates a little bit differently. You need to research the company, the management, the product, and so on. But if you are really doing your homework when you buy mutual funds and stocks (or anything for that matter), and I mean really doing your homework, you're going to find that that rule holds true for those financial products as well.

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This entry was posted on March 27th, 2008 by David C Lewis, RFC. Edits may have been made to keep this entry current. · No Comments · Insurance & Savings, Philosophy In Financial Planning