Study riles advocates of equity index annuity

Mar 6, 2006 @ 12:01 am

By Gary S. Mogel

NEW YORK - Equity index annuities are either an effective savings vehicle or a scheme to dupe the elderly- depending on whether advisers believe the annuities' supporters or a recent report that blasts such investments.

EIAs are high-commission, high-surrender-charge, tax-disadvantaged investment products, according to "An Overview of Equity-Indexed Annuities," released last month by the Securities Litigation and Consulting Group in Fairfax, Va.

"I got involved in researching EIAs after I got a call from the SEC in November asking me for my thoughts," said Craig McCann, the group's president. "They are obviously very interested in regulating or litigating them."

He previously was an economist for the Securities and Exchange Commission and an arbitrator with Washington-based NASD.

Critics of the study don't mince words.

The report is "reckless in its incompleteness," according to Michael Ebmeier, chairman of the National Association for Fixed Annuities in Milwaukee. "I don't mind a reasonable objection to a product line, but when something's just obviously maligned, it makes me feel beleaguered."

Some of the report's concerns are valid, but the frequency of the cited abuses is overstated, according to John Kawauchi, vice president of business development with Nationwide Financial Services Inc. in Columbus, Ohio. "It appears that the report cuts and pastes arguments from the variable annuity market," he said.

"This is a strong academic effort that ultimately fails to deliver an accurate conclusion," said David Macchia, chief executive of Wealth2K Inc., a Hingham, Mass., annuity marketing and consulting firm. The report's investment return comparisons are flawed, he said, because equity index annuities aren't investments but "long-term savings vehicles."

Cost gripes

The commissions, surrender charges and other expenses of equity index annuities result in 15% to 20% of the premium being "a transfer of wealth from unsophisticated investors to insurance companies and their sales forces," according to the report.

"EIAs are being sold as investment products, and for an investment product they have extremely high commissions of up to 12%," Mr. McCann said.

"Most EIA insurers target a 12% to 15% return over time, but that's not taken out of what the client puts in," Mr. Ebmeier said. Rather, insurers make their money and pay commissions out of the "spread"- the difference between what they earn and what they pay to the client, he noted.

The insurers require this spread over a certain number of years in order to reimburse their acquisition costs and to make a reasonable profit, which is the reason for surrender charges if the client withdraws the money early, Mr. Ebmeier added.

Equity index annuities more accurately are described as "tax disadvantaged," rather than "tax deferred," according to Mr. McCann, because money taken out of such an annuity is taxed at ordinary rates, which are much higher than capital gains rates, even for retirees.

"I don't see how deferring taxes can be a disadvantage," Mr. Ebmeier said. "If you have to pay a certain amount in taxes, it's better to pay it in the future, as you have use of the money during that time."

The report called the insurance benefits provided by the annuities "trivial." The benefits aren't life insurance but guaranteed minimum death benefits, which Mr. McCann characterized as "economically of no value."

"The GMDB is the amount of premiums less withdrawals and contingent on the client dying when the contract value is down," he said. The purpose of the benefit is to make the product look more like insurance so it can be regulated by state insurance departments rather than federal regulators, Mr. McCann said.

"The death benefits are not as rich as those provided by [variable annuities], but they're part of the tax-deferral benefit," Nationwide's Mr. Kawauchi said.

These products are so complicated that people with doctorates in finance would have difficulty understanding them, according to Mr. McCann. "It really takes a Monte Carlo simulation to determine the true return on these products," he said.

Mr. McCann also said that the product's "impenetrable" formulas have caps that "shave" the client's returns.

Complexity may be justified

"A complex vehicle is not inherently bad," Mr. Macchia said. He added that the complexity may be justified by the complicated "financial engineering" that equity index annuities require.

"There are many cars on the market with many different features. That doesn't make it too complicated to buy a car," Mr. Ebmeier said.

Regarding the caps, he pointed out that the insurers wouldn't be able to provide the downside protection without capping the upside.

"Even VAs are better for consumers than EIAs," Mr. McCann said. "They cost about half what EIAs cost, have prospectuses and are more transparent regarding fees."

Although NASD is attempting to make registered representatives disclose the risks of EIAs and make sure they are suitable, that isn't a solution for most consumers, Mr. McCann said, as 96% of EIAs are sold by insurance agents - over which NASD has no control.

"The fallacy of all these attacks is that EIAs are trying to replicate stock ownership, which they aren't," Mr. Ebmeier said. "EIAs appeal to an entirely different consumer - those who choose to forgo potential gains through implementation of the caps in return for downside protection."

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