From the November 2006 issue of Wealth Manager Web • Subscribe!

Drawing Swords

During a lull at an insurance conference last year, the topic of equity indexed annuities crept into the conversation. The talk centered on who had prompted the U.S. Securities and Exchange Commission to begin examining whether these annuities should be treated as investments. The probe originated after a couple of advisors had met with the SEC to share tales of alleged EIA abuses. The advisors later emailed so much backup material supporting their case that it crashed a government server--reacting as if it was under a spam attack. Chuck Newton, legislative director of the Financial Planning Association's Utah chapter, who attended the insurance meeting, was somewhat startled when he overheard a national board member of a large insurance agency say, "We'd like to find the guy who started this off. We want to kill him."

What the insurance executive didn't know was that Newton was one of the instigators. Under the circumstances, he wasn't about to divulge his role. "There are a lot of heated emotions over this," Newton observed. Actually, that would be something of an understatement. In this environment, it is rare indeed to find any professionals whose views on EIAs are tempered. When Donald Moine, a veteran financial industry consultant and an online commentator for "Morningstar Advisor," wrote articles about EIAs last year, he was astounded by the thousands--yes, thousands--of emails he received about this product.

It seems apparent that the battle lines are now clearly drawn. Professionals who sell EIAs believe these fixed annuities are a godsend to investors who are petrified of market volatility, but welcome the opportunity of potentially higher returns while protecting their backsides. Others believe the EIA is simply a pig wearing lipstick--a high-priced, worthless insurance product that confuses consumers and enriches salesmen. Against this backdrop, the SEC, and the NASD as well, are scrutinizing the industry's EIA practices, and trial lawyers have already filed class action suits against insurers and are threatening to file more.

Most EIAs are currently sold by insurance agents with a smaller portion sold by registered representatives who hold insurance licenses. Some registered investment advisors also recommend EIAs, but it's more likely for these advisors to encounter these annuities because clients already own them or are eager to buy one. But regardless of whether you sell them, are contemplating doing so--or just need ammunition to dissuade clients from sinking money into one-- it makes sense to understand what makes EIAs tick.

The insurance industry launched EIAs in the mid-1990s during a period when healthy stock market returns were sapping investors' enthusiasm for fixed annuities. With insurance agents enjoying far more success selling variable annuities, a segment of the industry decided to staunch the fixed annuity hemorrhage by adding equity octane to the product. And so the EIA was born.

The aim of the EIA is to capture a portion of the market's gain, while insulating investors against bad years. Almost every contract provides a minimum guaranteed interest rate of 3 percent, but typically this rate is based on 80 percent to 90 percent of the premium. For some contracts, this interest is only credited if investors hold their EIAs to maturity--often 10 years or more.

EIAs don't invest directly in the market. In hopes of achieving stock-like returns for this conservative investment, a portion of a customer's premium is used to buy options on the value of the stock that makes up a particular benchmark--most commonly, the Standard & Poor's 500 Index. The rest is sunk into bonds and other "safe" instruments. By holding options as well as bonds, an insurer can provide the guaranteed base rate even if the S&P 500 craters and the options expire worthless.

Insurers credit investors with returns that are based on index movements. A participation rate determines the fraction of the stock market appreciation--minus dividends--that is applied and can often range from 50 percent to 100 percent. For instance, if the participation rate is 80 percent and the index increases 5 percent, the return credited to the annuity would be 4 percent. A variety of formulas are used to translate the index's changes into a gross return. A point-to-point method can measure the index level at the start and end of a contract or on a monthly basis. Monthly averaging is another approach. And EIAs have even more working parts. The insurer, for example, can also impose participation caps and spreads, and many also charge an asset fee that can range from 2 percent to 2.5 percent.

Frankly, professionals often end up evaluating EIAs by reading marketing materials that are produced by insurance marketing organizations. Many of these IMOs are owned by insurance companies, design EIA products, and pocket a cut of the sales. Because EIAs aren't classified as investments, they are not required to produce prospectuses.

In the absence of much serious analysis of EIAs, a white paper titled "Exploring the Equity Indexed Annuity: An In-Depth Look for Financial Advisors," which was released in November 2005, jolted the industry. Mitchell Maynard, the author of the paper and principal at Premium Producers Group LLC in Orange, Calif., created the stir when he concluded that the potential performance gap separating the best EIAs from the rest was stunning. Maynard, who sells EIA analytical software, did not look at individual contracts, but rather examined eight crediting methods and back-tested hypothetical performance. A $100,000 investment in the S&P 500--used as the benchmark--would have grown to $1.3 million during a 40-year period ending in 2005. An EIA using an annual point-to-point calculation with a 55 percent participation rate and no cap grew to $1.1 million, which would have bested most mutual funds. In the study, the two worst crediting methods were monthly point-to-point with 100 percent participation and a monthly cap of 2.5 percent, and an annual point-to-point with 100 percent participation and an annual 8 percent cap. These methods only mustered returns of $428,614 and $366,065 respectively.

Morningstar's Donald Moine found the gulf between crediting methods alarming and is urging the industry to roll out better products. "The best EIAs are extremely good products that can stand up to any mutual fund," Moine concluded. "The problem is the majority of EIAs are simply not very good and are designed to benefit insurance companies and the agents rather than clients."

One reason why Maynard thinks more attractive EIAs aren't being offered is because the industry lacks incentive. Insurers and insurance marketing organizations, he contends, are more focused on sales than quality. "The insurance marketing organizations just want the bells and whistles, and they don't care about how good the EIA is. They just want it to be sellable," Maynard says, adding that he believes the EIA can be an "extremely valuable tool."

In still other research, Peter Katt, a fee-only life insurance advisor and the principal of Katt & Company in Mattawan, Mich., concluded that EIAs have no investment return advantage over fixed annuities. The EIAs tend to have larger commissions, which depress overall yields, he believes, but more importantly, the fatter commissions usually mean larger surrender charges for longer periods of time, making the product less flexible. "There isn't any outstanding reason to avoid EIAs," Katt says, "but I don't see any advantage over using fixed annuities."

Industry insiders such as Mike Tripses, executive vice president and chief actuary at Creative Marketing International Corp. in Overland Park, Kan. and chairman of the National Association for Fixed Annuities (NAFA), insist the criticism directed at EIAs is preposterous. "Companies are going to do their best in their construction of portfolios to make sure an agent and a client are not pitted against each other," he says. And he was "flabbergasted," he added, that critics would suggest that extra features and more choices could ever be a bad thing for consumers.

Tripses and NAFA also reserved harsh words for another paper, co-written by Craig J. McCann, a former SEC economist and president of the Securities Litigation and Consulting Group in Fairfax, Va. McCann began examining EIA contracts after the SEC contacted him last year for his opinion of the product. The paper, which can be accessed on the company's Web site (, estimated that 15 percent to 20 percent of the EIA premium paid by investors is a transfer of wealth from an investor to insurers and their agents. McCann, who is also a former managing director of securities litigation at KPMG, says it can take him up to a half-day to analyze a single contract, leading him to conclude that not even "one-half of 1 percent of stockbrokers in this country could understand the product." McCann, who has since been hired to assist plaintiffs in lawsuits against EIAs, insists, "These products are defective and shouldn't be sold to anyone."

Beyond battling researchers, some annuity boosters are preoccupied with rumblings from the regulators. Newton and Jeffrey D. Voudrie, CFP, president of Legacy Planning Group Inc., in Johnson City, Tenn., met with the SEC in a meeting facilitated by the Financial Planning Association last year. In a letter to the SEC, the FPA proclaimed its neutrality on EIAs. If the SEC--which has not revealed its hand--assumes oversight in the future, many expect it will take the action not because it thinks EIAs are an investment, but because of how they are marketed.

For the present, the watchdogs are the individual state insurance departments, which don't seem to be intimidating anyone. For example, Scott Dauenhauer, CFP and president of Meridian Wealth Management Inc. in Laguna Hills, Calif,, recalls that after sending the California Department of Insurance an inch-thick folder of EIA marketing materials he contended were clearly misleading, "Somebody called me back and said, 'What do you expect me to do? Go in and audit them?'" When Dauenhauer responded that audits would be an excellent idea, the bureaucrat replied, "We couldn't do that."

The SEC is not alone in poking its nose under the tent. Last year, the NASD issued Notice to Members 05-50, which warned broker/dealers that they'd better be watching what their troops sell. The NASD recommended that firms maintain a list of acceptable EIAs and prohibit brokers from selling any others unless they receive the firm's okay. The regulator also urged its members to consider requiring all EIA sales to be processed through the firm, meaning it would have to supervise marketing materials, suitability analysis and other sales practices. The NASD also said that broker/dealers should provide reps with proper training on the care and handling of these annuities.

What's more, the NASD also announced it would be auditing some broker/dealers to see whether reps who recommend that clients switch from variable annuities to EIAs are playing by the rules. According to one securities observer, such audits are actually a backdoor for the NASD to determine how EIA sales in general are being handled.

Indeed, the handling of EIAs, if not the product itself, may be a determining factor in separating the salespeople from the advisors.

Other Options

For advisors who would rather avoid EIAs, there are obviously plenty of alternatives to present to ultra-conservative clients. Addressing an investor's fear of equities is something most advisors have had to tackle. Exposing clients to a "Dummies" version of Modern Portfolio Theory can often dispel some of those fears. To reassure skittish investors, CFP Jeffrey D. Voudrie of Legacy Planning Group in Johnson City, Tenn., likes to share a back-testing scenario that illustrates how a simple portfolio of stocks and bonds can absorb the market's body slams as easily as an EIA. In Voudrie's example, an investor sinks 60 percent of his money into 10-year government bonds and puts the rest in an index fund that tracks the S & P 500 Index for 10 years--a typical EIA surrender period. He looked at the performance results for 529 rolling 10-year periods reaching back to 1950. In each of those 10-year stretches, the investor would not have earned less than 3 percent. In 80 percent of the periods, the returns were greater than 6 percent.

For those who favor insurance products, variable annuities now offer guaranteed minimum withdrawal benefits. Some also offer a guarantee of principal as a rider. And equity-linked certificates of deposit are also a safe, low-cost alternative. --LO

Lynn O'Shaughnessy ( is a financial journalist and former reporter for the Los Angeles Times. She is the author of the Retirement Bible and the Investment Bible (both Wiley).

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