Leaning on the phenomenal performance of the U.S. stock market during the past several years, insurance companies have come out with a complex hybrid product that looks like a high-yielding stock-based investment, but isn’t.
Equity index annuities, launched in 1995, are “the most successful new product launch in the insurance industry’s history,” says Jack Marrion, president of The Advantage Group, a research and consulting firm based in St. Louis. They now account for a whopping $3 billion in annual sales.
Unfortunately, some of that may stem from confusion over what an equity index annuity is and what it does.
Why? An equity index annuity looks like a stock, but performs like a bond.
Consider a brochure put out by Safeco Life Insurance, which offers something called the “Safekey Index Annuity.” All through the brochure, the annuity’s projected performance is compared to the performance of the Standard & Poor’s 500 index.
“While it is not a security, interest earnings are tied to the S&P 500 Composite Stock Price Index, excluding reinvested dividends,” the brochure says. “Additionally, the safety of your principal and interest is guaranteed.”
The brochure later charts hypothetical Safekey returns, based on the performance of the S&P 500 index over the past 40 years. But if you read the fine print, you’ll realize that your actual return will be substantially lower than an investment in S&P stocks–so much lower, in fact, that the comparison may be misleading.
Here’s why: First, all equity index annuities exclude reinvested dividends, which have historically averaged between 2 and 5 percent of total stock market returns in any given year. Then, they pay you just a portion of the S&P yield. Some companies, including Safeco, determine the portion they pay by subtracting a margin, or a percentage of the investment yield, to cover the insurance company’s costs. During the first several years of Safeco’s contract, that margin is set at 3 percentage points, but it can rise after the seventh year. With other companies, the yield paid is determined by multiplying a “participation rate” by the rise in the S&P. This rate typically ranges between 40 and 60 percent, says Marrion.
In some cases, the insurer also does not compound your interest earnings except for every five to 10 years, further reducing your investment earnings.
What does this mean in dollars and cents? Here’s a hypothetical example.
If you had invested $10,000 in the Safekey index annuity from Jan. 1, 1980, to year-end 1996, you would have ended up with a nest egg of about $38,499. If you had invested that same $10,000 in an S&P index fund, which charged a 0.50 percent annual fee but allowed you to reap a dividend yield and benefit from annual compounding (the Safekey product compounds just once every six years), you would have accumulated $119,684–three times more.
Insurers and planners who promote index annuities say that the deductions are a small price to pay for security. Safeco, and other index annuity companies, guarantee that you will never suffer a stock market loss. Generally, the worst you can do is earn a zero return in years that the stock market tanks. In a period of declining stock prices, an equity index annuity would look far better, they argue.
Does it? Yes. During a miserable period for stocks–from 1966 through 1976–a $10,000 investment in this S&P index fund would have netted a $16,483 nest egg. The same $10,000 investment would have grown to $20,380.54 in Safekey because the investor would not have suffered double-digit losses in 1966, 1973 and 1974.
However, all these comparisons to stocks may be sending the wrong message anyway, says Cindy DiBiase, president of NFC Consulting Group, a Chicago-based firm that works with insurers to develop new products. An equity index annuity is a fixed-interest product, more like a bond or guaranteed interest contract than a stock.
Indeed, when insurers figure the investment return that they will pass on to you, they not only look at the performance of the S&P index, they also consider the return on the insurance company’s total annuity portfolio, which is primarily made up of mortgages and bonds, DiBiase notes. Technically, your interest rate is not tied to returns of these fixed-income investments, but the insurance company often can alter your participation rate (or margin) if these returns are too low to pay you an adequate share of the S&P profits.
Consequently, over long periods of time, average annual returns on equity index annuities tend to mirror returns on fixed-income investments, not equity investments, Marrion says. Indeed, in the 17-year period studied above, the Safekey equity annuity would have paid an average annual return of 8.25 percent–a bit shy of the average annual return on intermediate-term government bonds over the same time period.
“The consumer who purchases this is typically a conservative consumer who doesn’t have the stomach to be in the equity market,” DiBiase says.
However, investors should realize that risk and reward go hand-in-hand in the financial markets. If you don’t want equity risks, you’re not going to get equity-like returns–regardless of what they call your investment product.
