Last week we introduced the analogy of annuities and icebergs – that though they may all appear compact, clean and pretty on the surface, you need to beware of what might be lurking unseen – and offered a brief overview of immediate annuities and fixed annuities. (If you missed this article, please email us at LifePlanning@kennedy-financial.com and we’ll send it you.) In this issue we’ll continue the subject of equity-indexed annuities. As far as variable annuities are concerned-there is so much controversy concerned in just the general understanding of these investment contracts that the regulatory authorities require us to file any written piece or auditory note describing these contracts to the general public with FINRA. If you have any questions regarding variable annuities, please feel free to contact us and we will be happy to assist you on a personal level.

An equity-indexed annuity combines some characteristics of both fixed annuities and equity like financial instruments. Above the water this annuity appears extremely attractive because it guarantees a minimum for the value of the fixed side of the annuity, but provides you the opportunity to earn returns tied to indexes of stocks, bonds and money markets. Underneath the surface, however, these icebergs may cause true Titanic stories. In each contract you are given a participation rate, which is the rate your annuity interest is linked to the index. For example, if your participation rate is 65% and the index goes up 10%, you will only receive 6.5% interest. Also, these rates can change after a certain period. Additionally, some contracts have a cap rate that limits the maximum amount of interest you can earn. If the contract has a 6% cap rate and your participation rate earned 6.5%, you would only receive 6%. Not all equity-indexed annuities have a floor on index-linked interest rates. Even worse, some can capture 100% of the downside of an index.

So…let me put this in perspective. Your contract states your indexed-linked account will capture 100% of the downside and the index dropped 20% last year. Your indexed portfolio is now down 20%. The index rebounds this year and earns 15%. However, there is a 6% cap rate so you only earn 6%. Next year, the index has another bull year earning 12%; however, you still only earn 6%. At this rate it would take more than 4 years just to break even.

Moreover, no dividends are paid on the indexes, and some contracts pay simple interest on the index term. This means your interest is added to your original premium year after year, and does not compound. So what questions do you need to ask?

What is the rating of the insurance company issuing the annuity contract? What is my participation rate? What are my investment options? Will I be forced into a fixed allocation, or can my advisor or I choose my investments? Can the insurance company move my assets to and from a fixed account without my permission? Or can I decide when to be in and out of the market? If I choose a living benefit, am I restricted to certain investments?   Is there a margin, spread or administrative fee? If so, what is it? What is the total cost of the annuity contract (Death Benefit Cost + Living Benefit Cost + Mortality, Expense Risk and Administration Charges + Sub-account Cost)? What is the indexing method (annual reset, averaging, high-water mark, low-water mark or point-to-point)? What do these mean? What is the cap rate? Is there a floor on equity index-linked interest? Is the interest compounding in the equity index-linked interest? What method is used if my plan changes and I have excess withdrawals (recalculated, pro rata, dollar-for-dollar/ pro rata)? What do these mean and how will it affect me? What are the surrender terms and charges?

Because our firm is considered independent, we are not tied to selling one company’s products, which we believe is crucial in determining if an annuity is right for our clients and if so, whether an annuity within the immediate, fixed, variable, or equity-indexed classification is best suited. This flexibility provides us the opportunity to explore many companies with a vast array of annuity contracts and has enabled us to develop an unbiased view at the annuity world. If you are looking to set sail on the annuity waters – which can be extremely rough – I strongly recommend working with an advisor who has the ability to work with several companies. This will not only give you more options, but also allow the advisor to find an annuity that is tailored to your unique situation.