By: Bryan Kupchik

Everyone enjoys a winning hand, and let’s face it, losing money is painful for all of us, no matter how much is at stake. This is why an Equity Indexed Annuity is so appealing to investors, the potential to ‘never’ lose money is an apple everyone wants a bite of, but this appeal may only be attractive at first glance.

Get a bit closer to the terms and conditions of an Equity Indexed Annuity, and many will find that this product is rarely ever a vehicle for gains, and often a sure fire way to keep your investment in the hands of an insurance company, and out of your reach.

What is an Equity Indexed Annuity, or “EIA”? An Equity Indexed Annuity, as defined by the Financial Industry Regulatory Authority, or FINRA, as “complex financial instruments that have the characteristics of both fixed and variable annuities,” and “are anything but easy to understand.” EIAs are sold by insurance company representatives as ‘all reward, no risk’ investments, where an investor will ‘never’ lose money. But is that true? And does that also indirectly mean that an investor will be guaranteed to make money? The answer on both counts, in almost all cases, is no.

There are a number of questions an investor should have answered before purchasing an EIA. In fact, FINRA issued an alert in 2010 to investors regarding the sale of EIAs due to the confusing nature of their performance. To alleviate some of this puzzling information, FINRA addressed the questions below as part of the alert:

Q: “How is an EIA’s index-linked interest rate computed?”

This is where we get into the fine print. Even on FINRA’s website, investors are clearly advised to understand the terms and conditions of the limiting and controlling features an EIA can place on an investment’s performance. FINRA lists a few of the contributing factors that can have a “dramatic impact on performance”:

A: “Participation Rates. A participation rate determines how much of the gain in the index will be credited to the annuity. For example, the insurance company may set the participation rate at 80 percent, which means the annuity would only be credited with 80 percent of the gain experienced by the index.

Spread/Margin/Asset Fee. Some EIAs use a spread, margin or asset fee in addition to, or instead of, a participation rate. This percentage will be subtracted from any gain in the index linked to the annuity. For example, if the index gained 10 percent and the spread/margin/asset fee is 3.5 percent, then the gain in the annuity would be only 6.5 percent.

Interest Rate Caps. Some EIAs may put a cap or upper limit on your return. This cap rate is generally stated as a percentage. This is the maximum rate of interest the annuity will earn. For example, if the index linked to the annuity gained 10 percent and the cap rate was 8 percent, then the upper limit maximum gain in the annuity would be only 8 percent.”

It is important to point out that, for most EIAs being offered in today’s marketplace, cap rates are much lower than the example on FINRA’s website.

Today’s cap rates are more likely to be in the 3 to 4% range and, also, many EIAs impose all three of the factors listed above in their contracts in order to limit potential gains for contract owners.

Further, FINRA goes on to state that any and all of the factors listed above, in many circumstances, can be changed by the insurance company, mid-contract, and potentially cause an adverse impact on an investor’s return. In the 2010 alert, FINRA urges consumers to question their insurance company about these conditions that can be written into an EIA contract.

Q: “Can I get my money when I need it?

In short, it is unlikely.

A: “EIAs are long-term investments. Getting out early may mean taking a loss. Many EIAs have surrender charges. The surrender charge can be a percentage of the amount withdrawn or a reduction in the interest rate credited to the EIA. Also, any withdrawals from tax-deferred annuities before you reach the age of 59½ are generally subject to a 10 percent tax penalty in addition to any gain being taxed as ordinary income.

Q: Can I lose money in an EIA?

A: Yes. Many insurance companies only guarantee that you’ll receive 87.5 percent of the premiums you paid, plus 1 to 3 percent interest. Therefore, if you don’t receive any index-linked interest, you could lose money on your investment. One way that you could not receive any index-linked interest is if the index linked to your annuity declines.

The other way you may not receive any index-linked interest is if you surrender your EIA before maturity. Some insurance companies will not credit you with index-linked interest when you surrender your annuity early.

In addition, all guarantees offered in EIAs are only as good as the insurance company providing them. Though very rare, it is possible that an insurance company may be unable to meet its obligations, thus leaving the consumer at the mercy of the insurance company’s financial stability. 

Some EIAs come with add-on benefits like additional life insurance, or a lifetime income benefit. It’s very important to point out that these benefits are insurance values only, and are not available for withdrawal.

Unfortunately, sometimes the interest rates used to calculate an additional benefit value (commonly referred to as “invisible money” in an EIA), are sold by the salesperson as if it’s the rate that an investor can earn.

For example, if you were told that your EIA is “paying” 7% that may not be the case and, instead, that rate is merely adding value to the “invisible money” in your EIA. Ask your agent to clearly explain the difference between the interest rates offered on an additional benefit and the actual rate of return you can earn on your invested dollars. Remember that, in a low interest rate environment, if the rate sounds too good to be true, it probably is.

You may be asking yourself why you were advised to purchase an EIA in the first place, since the likelihood for gains seems to be so slim. Well, many salespeople offering EIAs are representing insurance companies, and may be subject to conflicts of interest. Insurance sales reps can receive very large commissions, bonuses, and even incentives, like winning a vacation, in exchange for their sales efforts.

A typical commission payout for sale of an EIA can be as much as 10% of the investment, meaning that if you put $500,000 into an EIA, the person sitting across from you would be taking home $50,000 in commissions – certainly a motivating incentive and a real cause for concern about whose best interest is coming first.

It’s also important to note that some salespeople may not be securities licensed, which means they are not regulated by FINRA or the Securities & Exchange Commission. If your agent does not have certain FINRA securities license(s), he or she may be limited to only selling products like EIAs.

Before you enter into an EIA contract, be sure to get every question answered, and understand that the long term commitment you are making can come with possible consequences. You should read the entire contract prior to your purchase and be sure that you have all the straight facts about the product you’re being sold.

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Bryan Kupchik is a Certified Financial Planner, Chief Compliance Officer, and co-founder of Capstone Wealth Management Group, LLC, a registered investment advisor located in Clarks Green.