Equity Indexed Annuities -- A Sucker's Bet
The heat is on. More and more articles ("Popular Annuity Can Be Tricky," WSJ, 10/15/05; "EIAs: Behind the Hype," Financial Planning, October 2005; "Do Clients Understand Equity Indexed Annuities?," Morningstar Advisor, 10/27/05) are raising the warning flag about equity indexed annuities (EIAs). And, rightly so. EIAs are a great example of an investment product designed to be sold but not bought. The whole premise of EIAs plays on the fears of uneducated investors. The product pushers oversell the risks of equity investing to the point that the purchasers are willing to give up huge portions of upside return in order to be protected from the exaggerated downside risk.
Investment risk needs to be put in perspective. First of all, investors need to understand that risk and reward go together. It's fundamental. If you don't want to take risk, then don't expect a huge return. If you want a huge return, then don't expect to do it without risk. Sure, there are anecdotal exceptions, but those have more to do with luck than skill. Diversification is the way to minimize risk and optimize expected returns, but that's a subject for another day.
The second point is that time reduces the probability of a sustained loss. That's why we're big proponents of long-term investing. Let's check the record using the S&P 500. The worst one-year loss for the S&P 500 beginning in 1926 was -43.4% in 1931. The worst ten-year period? An annualized loss of only -0.90% (1929-1938). The worst 20 years? Surprise! Not a loss, but a +3.1% annualized return (1929-1948). Furthermore, most investors overestimate the history of loss years. See my August 31, 2005 blog, but also consider that in the 79 years 1926 - 2004 over 70% of the years the S&P 500 had gains (non-negative returns), and the average return of the good years (non-negative returns) was 22.7% versus the average -12.6% loss of the bad years (negative returns).
So, back to EIAs. Folks who buy EIAs are so fearful of a loss they're willing to live with an 8%-13% commission to a broker, surrender penalty periods of ten years or more, about one-third of the return of the actual index, tax penalties for withdrawals before age 59 1/2, no dividends, and no capital gains treatment for the appreciation. Some deal. Which is why EIAs are only sold to little old ladies and the unsuspecting. Which is why the SEC and the NASD are beginning to take notice.
Investment risk needs to be put in perspective. First of all, investors need to understand that risk and reward go together. It's fundamental. If you don't want to take risk, then don't expect a huge return. If you want a huge return, then don't expect to do it without risk. Sure, there are anecdotal exceptions, but those have more to do with luck than skill. Diversification is the way to minimize risk and optimize expected returns, but that's a subject for another day.
The second point is that time reduces the probability of a sustained loss. That's why we're big proponents of long-term investing. Let's check the record using the S&P 500. The worst one-year loss for the S&P 500 beginning in 1926 was -43.4% in 1931. The worst ten-year period? An annualized loss of only -0.90% (1929-1938). The worst 20 years? Surprise! Not a loss, but a +3.1% annualized return (1929-1948). Furthermore, most investors overestimate the history of loss years. See my August 31, 2005 blog, but also consider that in the 79 years 1926 - 2004 over 70% of the years the S&P 500 had gains (non-negative returns), and the average return of the good years (non-negative returns) was 22.7% versus the average -12.6% loss of the bad years (negative returns).
So, back to EIAs. Folks who buy EIAs are so fearful of a loss they're willing to live with an 8%-13% commission to a broker, surrender penalty periods of ten years or more, about one-third of the return of the actual index, tax penalties for withdrawals before age 59 1/2, no dividends, and no capital gains treatment for the appreciation. Some deal. Which is why EIAs are only sold to little old ladies and the unsuspecting. Which is why the SEC and the NASD are beginning to take notice.
posted by Sherman L. Doll, CPA/PFS at
10:34 AM
