A consultant shines a light into the dark hole of equity-indexed annuities.

    Most financial advisors know that equity-indexed annuities are a seriously flawed product, appropriate for almost no one. Yet, according to an April 2 report in the National Underwriter, sales topped $25 billion last year. Someone is buying them. So what to do when a new client comes in with such an annuity already in his portfolio? Dump it? Wait until the hefty surrender charge disappears? Take penalty-free withdrawals? Maybe.
    Introduced in 1995, equity-indexed annuities were touted as a way to get hold of a stock market return on the upside while receiving a guaranteed return on the downside. What could be better for a conservative investor who had become frustrated in the mid-'90s because he was losing out on the biggest stock market boom in history? No risk, great return. But of course, the pitch turned out to be an empty promise. Both fee advisors and financial journalists slammed the product right from the start, arguing that it was riddled with hidden costs and unsuitable for retail investors. But sales took off anyhow.
    Craig McCann, Ph.D. and CFA, and Dengpan Luo, Ph.D. and CFA, of Securities Litigation and Consulting Group in Fairfax, Va., wrote in a 2006 research paper that the annuities carry "exorbitant and indeterminable costs, lack of federal regulation and an inability to decipher what the investments will earn," among other problems. "Equity-indexed annuities are complicated investments sold to unsophisticated investors without the regulatory safeguards afforded to purchasers of similar investments," the two researchers said. "We estimate that between 15% and 20% of the premium paid by investors in equity-indexed annuities is a transfer of wealth from unsophisticated investors to insurance companies and their sales forces."
    Although the complexity of these products "makes it virtually impossible even for brokers and agents to properly evaluate the annuities," McCann and Luo wrote, "salesmen can readily determine that commissions paid for selling equity-indexed annuities-as high as 10% or 12%-are much larger than commissions paid on mutual funds and variable annuities."
    Again, many financial advisors understand all of this. But many retail investors do not. And so it was that a client of Glenn Daily, a fee-only insurance consultant in New York, brought him a number of the annuities her mother had purchased and asked Daily to evaluate them. He examined several fixed annuities. Although he knew an analysis of the equity-index annuity would not fit in his client's budget, he was intrigued by the challenge and he started poking around at the annuity's assumptions on his own time.
    In 2001, his client's 76-year-old mother had put $50,000 into an equity-indexed annuity with an initial surrender charge of 17.5%, which declined over 16 years. The annuity's return was tied to the Standard & Poor's Index of 500 stocks with a 3% guaranteed floor. "Mom" initially liked the insurance agent but they'd had a falling-out by the time Daily was asked to look at the contract last year. The contract was under water. The surrender charge was 15%. "The sales pitch was 'no risk,'" Daily says.
    After Mom bought the contract, the S&P went down. The cap on the indexed account, which was 11.5% when she bought it, minus the 1.5% asset fee, had gone down to 9% with no explanation. In November 2005, the indexed account value was $50,653. The minimum guaranteed value was $53,460. If she chose to cash it in, she would be left with $44,907 after the surrender charge, a loss of 16%.
    When customers buy such an annuity, they see it as the best of both worlds. What will their situation be if the market drops? "I won't be losing any money," they reason. "I can just get out later." Daily's calculations revealed just how expensive it could be to get out later.
    Because Daily knew the cap was set at 9% for 2005-2006, he could predict that, after the asset fee of 150 basis points, the maximum "Mom" could have in her indexed account was $54,452 in November 2006. The guaranteed minimum contract value would be $55,064. So there was no chance the indexed account value could exceed the minimum account value as of November 2006. And there was no chance she could come out whole because of the surrender fee.
    The cap is reset every year by the insurance company with no explanation of what the new interest-crediting rate is based on. The indexing strategy on Mom's policy is based on the point-to-point increase in the annual value of the S&P 500. Some contracts are reset monthly and a number of other interest-crediting options exist, making it very difficult for a retail customer to guess what the return might be. Instead, the customer focuses on that "promise" that he will never lose money because he has a guarantee. Suppose the S&P gains 7.24%. You subtract the 1.5% asset fee and the indexed account grows at 5.74%. The return does not include the dividends paid by the S&P 500. And we know that the dividends are key to growing stock market investments.
    The interest crediting rate is not linked to anything, not to the cost of hedging with options on indexes, not to any stock market measure or published interest rate. "The most common arrangement is that it is guaranteed for the first year," Daily says. Perhaps the 11.5% was a teaser rate. But nowhere in the contract does it say so. The policy says that, "Our board declares the cap for the year coming up," but "they don't have to file a reason for the change," he says. "They would probably say that they have to be flexible in order to cover the cost of hedging." So it's "indexed," but to what? "How can you call it indexing when the company controls the interest rates?"
    Daily realized that it would be most difficult to decide whether to tell a client like "Mom" to just drop the bad policy and swallow the surrender fee or to stick it out. So he set to work analyzing it, keeping track of the two separate account values, the cap, the floor and the fees on it.
"This was the first time I ever analyzed an indexed annuity," Daily says. "The pitch is that you get the best of both worlds, but the truth is people don't think about what will happen if you go below the floor. They think: 'What will be my situation if the indexed S&P drops? I won't be losing any money. I can just get out later.'" That is a lesson of this product that is subtle. How will you feel if the market goes down? Now "Mom" is sitting with $54,542 and the market went up more than that. She is under water by 1%.
    Just about then, Daily was approached by another client, this one a chartered financial analyst whose client was an engineer-Daily's kind of client.     "That put me on the road to thinking that there is a need for a service to do this," he says. Both the advisor and client understood Monte Carlo simulations and were able to follow Daily's analysis. On this contract, the indexed credit cannot be negative. There is no maximum cap; there is a minimum of 8%.
    This time, Daily decided to go to the library, do some research and develop a prototype for his analysis that he could offer through his Web site, www.whatsmypolicyworth.com. "I don't know how you could give competent advice without doing a simulation," he says. "What are the chances, if I hold this for ten years, that I'll do better than some benchmark?"
    Once he'd analyzed the two annuities, Daily figured he could piggyback on the work he'd already done and offer to analyze equity-indexed annuity contracts for $495 for one interest-crediting method and $125 for each additional method. He prefers to work with financial advisors rather than the annuity holders because of the complexity of the product. His new service became available in mid-April.
    Isn't it frustrating when being a financial advisor means you're required to clean up other people's messes? And the worst products are always the most complex-the better to eat you with, my dear, said Grandma the wolf to Little Red Riding Hood.

Mary Rowland has been a business and personal finance journalist for 30 years, a half dozen of them as a weekly columnist for the Sunday New York Times. She wrote a column called Practice Points for Bloomberg Wealth Manager for six years. She speaks regularly about money and values. Her six books include two written for financial advisors: Best Practices and In Search of the Perfect Model.