Hi There !

This is a long question that requires a short answer.  

I am accumulating more information on Equity Index Annuities (EIA).

Most web sites advise against these investments because of:
(1) high fees
(2) taxation as ordinary income upon disbursal

But the three annuities I've investigated all offer a 
guarantee against principal loss if held to maturity----just 
like a bank certificate of deposit.  However, the guarantee
comes from the insurance company and not the government.

This deal seems too good to be true.  That is, these three annuities
appear to give most of the upside (90%-100%) of the stock market (S&P
500 index).  But the investor also gets a guarantee against losing any
money if the market declines.

If these annuities are legitimate investments, then the "high fees"
complaint doesn't make sense to me.  Wouldn't most investors be happy
to pay high fees to get a guaranteed investment that goes up with the
stock market?

I must be missing something.  If I'm not missing anything, then why do
so many financial gurus advise against annuities?

A 5-star answer would be 2-3 paragraphs.  No web sites or supporting
documentation required---just your opinion.

All comments greatly appreciated !
ron

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Request for Question Clarification by pafalafa-ga on 29 Feb 2004 18:55 PST

>>most of the upside (90%-100%) of the stock market<<

What leads you to think this?  I'm no expert, but the EIA's I've seen
generally lock in a fairly modest interest rate -- say, 1-3% -- for a
long period.  That's well below the general long-term performance of
the stock market.  And despite the guarantees against losing
principle, if inflation picks up and exceeds the EIA interest rate,
the overall value of the investment will decline in real dollars.

Am I missing something?  Are we talking about the same types of
investments, or did you have something else in mind?

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Clarification of Question by nronronronro-ga on 29 Feb 2004 19:32 PST

Thanks, pafalafa, for your question.

We are indeed talking about different things.
I believe you are referring to the "guaranteed floor,"
whereas I am referring to the "participation rate."

Both are detailed at this web site:

http://www.annuityadvantage.com/equityindexed.htm

Please let me know if you need more information.

Thanks!
ron

P.S.  I agree about your explanation of inflation affecting the results.
However, the 90%-100% participation (with a guarantee) still seems
like a grrrreat deal to me.  What do you think?

nronronronro - excellent to see you back here again!!

This is a very interesting question; as we know, there is no such
thing as a free lunch and whenever something seems to good to be true,
well, it probably is, right?!

"Equity Index Annuities" is a misnomer - it's an advertising gimmick
meant to reel in unsuspecting investors.  In practice, these annuities
have caps so that you will only enjoy some of the appreciation of the
stock market, and not all of it.  As an example, an annuity may have a
6% cap - so, even if the participation rate is 90% and the market is
up 12%, you will get 6% and not 10.8%.  Caps differ, but they are
likely to negatively correlate with participation rates, so that the
higher the cap, the lower the rate (effectively, this means you are
paying higher management fees for higher caps).

As is probably now clear, these annuities are therefore not really
different from regular annuities - the difference is in the way
interest is calculated, and the insurance company will make out like a
bandit if we repeat a period such as the 1970s...  Based on the
implied (typically inaccurate) claim of market returns, managers of
these products do extract higher than average fees.

What else?  Of course, there is no FDIC insurance.  While insurance
companies are regulated and must manage adequate reserves, who's to
say insurance company management will not engage in fraudulent
behavior ala Enron, MCI or Global Crossing??  Recent mutual fund
scandals provide a striking example.  So, while the law dictates such
reserves, when the time comes to pay up there is some risk that there
will be no such reserves...

The tax claim, while correct if one plans to withdraw a lump sum
payment, can be mitigated by taking periodic payouts.  Especially if
one's retirement income is average, this is not a critical
consideration.

Finally, my personal belief is that a semi-intelligent active investor
will do better managing his own savings by investing in a
well-diversified portfolio of mutual funds through Roth IRAs, 401ks
and other retirmement type accounts.

I am of course available for additional deliberation as needed!!!

thanks,
ragingacademic

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Request for Answer Clarification by nronronronro-ga on 01 Mar 2004 10:02 PST

Thanks, ragingacademic, for your clear argumentation !

Your answer is already worth 5 stars.  But could you please write 1-2
sentences on the value of the guarantee.  This appears to be one area
where these annuities have an advantage over the small do-it-yourself
investor (who typically cannot guarantee his portfolio).

When I think of all the people who lost a fortune from 2000-2002,
seems to me this annuity guarantee feature could be very
valuable-----even with the high fees.  What do you think?

ron

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Clarification of Answer by ragingacademic-ga on 01 Mar 2004 10:45 PST

nronronronro - of course.  The key, I think, is in the perspective you
take on these "Equity Index Annuities" - they are not really an
alternative to investing in the market, they are just another flavor
of the standard annuity contract.  The verbage happens to be such that
they SOUND like a stock market type investment, but the whole stock
market argument is really just another way of setting rules and
contraints for the payout.  The guarantee, therefore, is the same
guarantee of principal any annuity buyer receives - don't you think?
There is really nothing materially different here.

I think the key is to present this product to clients as what it truly
is - a different spin on the annuity product.  btw, watch the fine
print carefully because some of these will pay NOTHING if withdrawn
prior to maturity...

As for the small investor in the market - if you can lead clients to
construct well-diversified portfolios, then with a 15 year plus
horizon, and given that they do not invest in individual stocks, they
should do well.  The people who really took a beating were those who
were invested in the "99 club" (Internet stocks that declined more
than 99% from their highs), or those who were heavily into technology.
 Discipline and diversification is key.

thanks again -
ragingacademic

Terrific work, ragingacademic.  I appreciate it !

ron

Hi, Ron

Like you, I am always wary about investments that sound too good to be true.

I had never heard of these until you posed the question but my
experience of insurance companies is that they can be downright
sneaky.

I just wonder ...

How many folks would hold on to these investments until maturity?
(Here in the UK, endowment policies yielded apparently high, safe
returns because the insurance companies paid out huge terminal
bonuses. However, most of these schemes have finished bottom up and a
lot of folks lost their investment; others did not get the payout that
they expected.)

And what would they get if the Stock Market collapsed? (It's ALWAYS
happening from time to time.)

The three things that are sure in this life are that the salesmen
always get their cut; the Inland Revenue always grabs its share; and
the legal profession always makes a killing when things go wrong.

Warmest regards

Bryan

Thanks, Bryan, for your comments.  They resonate deeply.

As your man, Sir Winston, once said:  "Men occasionally stumble on the
truth, but most of them pick themselves up and hurry off as if nothing
had happened."

Thanks again.
ron

Great quote, Ron. Many thanks!