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No Such Thing As a ‘No-Fail’ Investment

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Q. After losing half of my retirement portfolio in 2008, my financial advisor recommended a product which is guaranteed not to lose money when the market goes down but also goes up when the market goes up. Why would anyone not invest in this?

Q. After losing half of my retirement portfolio in 2008, my financial advisor recommended a product which is guaranteed not to lose money when the market goes down but also goes up when the market goes up. Why would anyone not invest in this?

As with most things in life, in investing there’s no free lunch. If an opportunity – like an equity-indexed annuity – seems too good to be true, read the fine print.

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Sounds like the ideal investment, doesn’t it? You gain when the market gains, but you don’t lose when the market tanks. You’ve reached the holy grail of investing. What could possibly be wrong with that?

Well it turns out there’s a lot wrong with that.
I’m referring to an equity-indexed annuity, whose sales increased dramatically after the 2008 financial crisis and which now account for almost 40% of fixed annuity sales according to some reports.

In a fixed annuity the insurance company pays you a guaranteed rate of interest, and in a variable annuity you “invest” a portion of the annuity premiums in mutual fund-like subaccounts so the rate of return isn’t guaranteed.

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An equity-indexed annuity (EIA) lies somewhere in between fixed and variable annuities in that it gives you a minimum guaranteed interest but on top of that it can credit you with additional interest that is linked to a stock market index such as the S&P 500 Index.

So what’s not to like?

Reason #1: It’s complicated to understand

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Have you ever read a disclosure statement or prospectus from an annuity? I suggest you take 800 mg of ibuprofen before you attempt it. Here’s a real quote from one equity indexed annuity provider’s disclosure statement:
“This annuity is a modified single-premium deferred fixed modified guaranteed indexed annuity.”
—Source: Phoenix Reflections Gold Bonus® Indexed Annuity Disclosure Document

I may never win a Pulitzer Prize, but I’m confident I can write a little clearer than that! If you can decipher the code language in these contracts, you should work for the NSA.

Reason #2: It’s not an investment

With an EIA you aren’t actually buying any securities, shares of stocks, or mutual funds. Instead, an EIA is a contract between you and an insurance company who promises to make payments to you either now or in the future. So ultimately what is paid to you is only as good as the underlying strength of the insurance company you buy the contract from. While it’s unlikely the insurance company will go belly up, it’s still an inherent risk.

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Reason #3: It doesn’t fit with an overall portfolio

Since an EIA isn’t directly an investment and its long term return lies inbetween CDs and stocks, it’s impossible to classify what it is. Is it a stock or bond? Or a combination of both? Your stock/bond allocation is one of the primary drivers of your investment return, but since an EIA is neither, how do you fit this into your overall investment plan?

Reason #4: It severely restricts your gains

Suppose you buy an EIA which which has a guaranteed minimum interest rate of 2% and is also linked to the return of the S&P 500 Index, a measure of US large company stocks. Let’s say that the S&P 500 Index gains 10% over 12 months. You may think that your EIA’s rate of return is 12% (2% guaranteed minimum + 10% additional interest linked to the S&P 500 Index).

Unfortunately an EIA has a several methods to limit your gains. First is the participation rate, which is a percentage of the index gain that is credited to you. This is usually somewhere between 70% to 90%. In the example above you wouldn’t get the full 10% S&P 500 index gain. Instead you’d get around 8%. However even that is further restricted by an index cap, which is the maximum absolute percentage gain that can be credited to you. An index cap of 4% would then limit your index linked interest to 4% –even lower than what you would get with the participation rate alone.

On top of all that the insurance company may change the participation rate and index cap periodically.

Reason #5: it’s expensive…REALLY expensive

Some insurance agents who sell EIAs are bold enough to state that there is no management fee associated with buying an EIA. I suppose technically that’s true because an annual management fee is something you’d pay out of your own pocket for an advisor to manage your investment portfolio. The “no management fee” pitch gives you the illusion that EIAs are low cost products.

But the reality is that when an insurance agent or financial advisor sells you an EIA, he’s likely getting a fat commission which can approach 10% of the amount you purchase! On a $100,000 initial buy-in to an EIA, that’s quite the payday. Can you say “conflict of interest?”

It gets worse if you buy an EIA and then want to get out. You’ll likely be stuck with a penalty called a surrender charge which can run over 10% of the amount you want to withdraw. And that doesn’t go away for up to 12 years after you bought the EIA. Talk about locking up your money!

To really hammer it in, there’s another hidden fee you’ll never know unless you ask, though I bet the financial advisor who is selling you this stuff probably doesn’t know about it either. If you invest in a mutual fund which tracks the S&P 500 Index, you will get the return of the index plus dividends. In an EIA the index linked interest payment excludes dividends. Since the divided rate is around 2% – 3% annually, that’s another fee you’re paying since you lose out on those gains.

Finally remember that investment returns come from taking risk. If you’re too scared of stock market fluctuations and can’t stand to lose any money, then perhaps you shouldn’t be in the market at all. Buying an EIA probably isn’t your solution.

Setu Mazumdar, MD, CFP® is board certified in EM and he is the president of Physician Wealth Solutions.
www.physicianwealthsolutions.com

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