Equity-indexed annuities sound good, but...
Are equity-indexed annuities a good investment?
That's one of the top five questions in my mailbag these days. Thousands of people attend free dinners and lunches every week to learn about the miracle investment that will give them near-stock-market returns without the trauma .
The basic offer of an equity index contract is this:
For the millions of investors who lost small or large fortunes in the 2000-2002 bear market, the idea of never losing money has a lot of appeal. Since equity-indexed annuities (EIAs) are often sold as a win-win proposition, investors have poured billions into them .
But is it really that good?
There's no easy answer. The contracts are so varied and so complicated it is next to impossible to benchmark them. One result is that salespeople often make extravagant claims.
How extravagant? Enough that the National Association of Securities Dealers declared in 2005 that it was "concerned about the manner in which associated persons are marketing and selling unregistered EIAs, and the absence of adequate supervision of these sales practices."
My translation: These things are being sold willy-nilly and are likely to become a big-time source of expensive lawsuits for brokerages that sell them.
Unfortunately, that still doesn't tell us much about the actual investment. I grumbled about this to John R. Fahy, a former SEC enforcement lawyer in Fort Worth. Fahy, who developed a dark and wry sense of humor at the SEC, now serves as legal counsel to investment firms. Not to worry, he said; a study of EIA performance had been done by two PhDs in financial economics from leading graduate schools, Craig McCann (UCLA) and Dengpan Luo (Yale).
The study, believe it or not, is very readable. It is also available free as a PDF download. If you're about to head for an event celebrating the cosmic benefits of equity-indexed annuities, I suggest you read this document first. If you like making people squirm, show a copy to your enthusiastic salesperson.
For those who can't wait, the study estimates that "between 15 percent and 20 percent of the premium paid by investors in equity-indexed annuities is a transfer of wealth from unsophisticated investors to insurance companies and their sales forces."
Benchmarking against a simple $100,000 portfolio consisting of 60 percent 10-year Treasury strips and a low-cost S&P 500 index fund, the two researchers did a Monte Carlo analysis of probable returns. The simple portfolio beat the equity-indexed annuity a whopping 96.9 percent of the time.
Moreover, after 10 years, the expected benefit of the equity-indexed annuity was only $219 when it did better, but the expected benefit from the simple portfolio was $33,650. Researchers McCann and Luo concluded that EIAs cost the investor about $153 for every $1 of possible benefits.
If you're still looking for a way to think about this product, try this: An equity-indexed annuity is the inverse of a hedge fund. The typical private hedge fund offers to take extreme risk in the pursuit of gain in exchange for 2 percent of principal and 20 percent of any gain. The typical EIA offers extreme safety in exchange for all dividends (about 1.7 percent a year for the S&P 500) and 50 percent of the capital appreciation.
Hedge funds are a lousy deal for the rich. Equity-indexed annuities are a lousy deal for the rest of us.
Scott Burns is a syndicated columnist. He can be reached at scott@scottburns.com. 
