If you are an elderly investor looking for a conservative way to invest in the stock market, you should be aware of an Investor Alert recently issued by the Financial Industry Regulatory Authority ("FINRA") regarding the dangers of equity indexed annuities ("EIAs"). In contrast to the way they are often sold, EIAs are in fact complicated with confusing features that make them difficult to understand. As a result, they are often misunderstood to be solidly conservative investments.
An annuity is a contract between a purchaser and an insurance company that promises to make periodic payments. Annuities are either "fixed," meaning the insurance company guarantees the rate of return as well as the ultimate payout, or "variable," meaning that the rate of return varies with the performance of the investments (stocks, bonds) purchased within the annuity. Unlike fixed annuities, variable annuities carry the risk of loss if the underlying investments decrease in value. As a result, variable annuities are considered securities and are registered with the Securities and Exchange Commission ("SEC"). Fixed annuities escaped similar regulatory oversight due to a late amendment to the Dodd-Frank Wall Street Reform and Consumer Protections Act passed in July 2010, even though the stocks purchased within the fixed annuity remain subject to SEC regulation. As a result of this exeption, sellers of fixed annuities do not have to be licensed securities brokers.
EIAs have characteristics of both fixed and variable annuities because their value is dependent on the performance of the stock indices they track except they do not decline in value if held to maturity even if the underlying indices they track do decline. As a consequence, the returns vary more than a fixed annuity but less than a variable annuity with a risk of loss that is less than variable annuities but more than fixed annuities.
In the abstract, EIAs may seem to some investors to be an attractive middle ground between fixed and variable annuities. As FINRA describes them, however, EIAs are complex financial instruments that are not well understood by the general investing public. The gains that are linked to the performance of the underlying index is dependent on various features that an EIA uses. For example, insurance companies often limit the percentage of the stock index increases that is credited to the annuity. Moreover, some insurance companies add a spread/margin/asset fee which is subtrracted from any gain in the index linked to the annuity. Other EIAs place a ceiling on the amount of the annual return the annuity can gain. These an other features reduce the gains which EIAs can achieve. Therefore, conservative investors may not find these investments suitable.
EIAs not only limit the upside potential, they are structured to be long-term investments that carry significant penalties if the investor needs to withdraw his or her funds early. Investors who pull their money out of EIAs early may suffer losses that occurred in the underlying stock index. Such investors typically also face surrender charges that further add to the losses. Additionally, any investor who withdraws from tax-deferred annuities before the age of 59 1/2 are subject to a 10% tax penalty in addition to having any gain taxed as ordinary income. As a result, elderly investors may question the suitability of EIA investments.
