Immediate vs. Deferred Annuities
The first basic distinction among annuities contracts is between immediate vs. deferred. As we have seen in the preceding blog posts (Part II and Part I), all annuities are designed to be irrevocably converted into income at some point, by definition.
We might even say that deferred annuities—those that appear designed to grow like bank or investment accounts and offer some access to our principal—are simply waiting to grow up into immediate annuities, at which point our claim on principal goes poof, and we have only a stream of periodic checks where once was a mighty pool of liquidity. Once again, by contract and by design, a deferred annuity is an immediate annuity waiting to happen.
In a moment, we are going to pretend that there really is a distinction, but you MUST forever bear in mind that annuities are designed to ultimately convert liquid principal into income according to some contractual scheme. This is a fundamental characteristic of what annuities are. We’ll get into a bit more detail later, and for now will focus on the very basics. Ok, here we go.
Equity index annuities – complex derivatives products with scant regulation
The last wicked twist on fixed annuity contracts is the increasingly popular equity index annuities (EIAs). These are important, and have become quite pervasive. These are enormously complicated contracts that pay interest that is based on the performance of securities indices, like the S&P500.
Because they are fixed contracts, they can offer principal guarantees and guaranteed minimum interest, but often are so low as to appear negative even before the sometimes-massive surrender charges that they carry.
Remember the example of the elderly couple and the “nice man from the library” earlier in the blog series? Surrender charges on that product—after receiving the guaranteed interest on only 70% of their principal—amounted to a whopping 48% of their money. The pitch with these is that you can have the security of a guaranteed product with the upside of the stock market, which is a very compelling notion.
Of course, this kind of security comes with a cost. Besides surrender charges, EIAs often typically apply cap rates; your return is limited to some cap, like maybe 10%, even if the market goes up 100%.
Participation restrictions – getting a smaller piece of market returns
They also often impose participation restrictions (“par rates”), whereby you only get a portion of the return, with the rest going to the insurance company. For instance, if your participation rate is 80%, and the underlying index is 5%, you get .8 x 5% or 4%.
The basic EIA structure is something like this: the insurance company bundles your money with that of other annuity buyers’ to buy a bond portfolio that pays interest. You get a portion of that interest, as does the insurance company, and some of it goes to buy options on the stock market; if the options hit, you get some of the gains, and the company gets some too. The principal guarantees are based on the bonds but ultimately guaranteed by the insurance company, not the bonds
Many ways equity index annuities can charge fees and shave returns
It gets much more convoluted, and can involve MVA risk, specific participation periods and methods, ongoing investor management requirements, and more.
Besides par rates, you may encounter spreads, cap rates (market does 40%? Sorry you are capped at 10% – before we apply your 60% par rate bring your gain down to 6% before other fees and adjustments) and lots more terms the insurance company lawyers keep dreaming up. The objective? Marketing pitches that seem irresistible but with convoluted contracts that drive insurance company profits on your money in hard to spot ways.
This is really just the tip of the iceberg on these complicated, derivative products, and you should read very carefully to make sure you understand before buying one. Or better yet pay an advisor or analyst who actually understands these to decipher it for you.
Creative annuity accounting – real money verses derivatives’ notional formulas
One last thing EIAs often share with other annuity types is multiple and misleading “accounts.” Besides tracking accumulation and surrender values, EIAs often have income accounts, a number that only has meaning if you decide to convert to income payments, but is not a cash value you can redeem.
EIAs provide a bundle of features—convertible guaranteed lifetime income that can’t be outlived, principle and sometimes minimum return guarantees, and access to participation in securities markets’ returns without actually being securities—that are important and generally impossible for consumers to build on their own without an insurance company component.
Products can be attractive but very complicated, and are often expensive and come with potentially disturbing liquidity restrictions.
In my view, EIAs can offer some of the greatest benefits and biggest dangers in the investments landscape today. Sadly, nearly all are so complicated that consumers will have a very hard time sorting the good deals from the many pigs in the poke.