Friday, January 9, 2015

Want A Free Lunch?

Pathways Advisory Group, Inc.
Dustin J. Smith, CFP®

In case you missed it from the September 2011 Newsletter...

Would you like a portfolio that never loses money?  Would you like a portfolio that increases with the stock market in good years and maintains principal in bad years?  Would you like a “free lunch”?  Would you like to come to a free dinner to learn about a “free lunch”?  Sign me up!

Although the intro may be a bit extreme, Equity Indexed Annuities have made bold claims for years.  It’s a compelling story, especially with hindsight.  Equity Indexed Annuities began in 1995. Somewhere along the way they were renamed Fixed Indexed Annuities.   The Fixed Indexed Annuity (FIA) market has experienced dramatic growth the past few years.  If you open your mail or listen to the radio, surely you have been invited to a free steak dinner to discuss a “free lunch”.

What occurs at these dinners?  I am sure every gathering is different, but they likely begin by establishing the risk of the stock market and the dishonesty of “wall street”.  Not a difficult sell.  The discussion probably transitions from there to a question and answer.  What if you could lock in your gains after the next 2007 and protect yourself from losses during the next 2008?  Sound good?  Of course it does. 

What is the catch?  You don’t really know until you invest.  It is difficult to pinpoint.  It’s hard to get your hands on the fine print before investing.  You have an initial grace period (you can get out penalty free) but it isn’t really long enough to observe the policy features.  Following the initial grace period, huge surrender penalties apply for a decade or longer.  However, most policies do allow a ten percent annual penalty free withdrawal.

What typical policy features make the “free lunch” claim misleading?  First, you do not lock in a high point in the market unless it occurs at a policy reset date.  Second, results are tied to an index, typically the S&P 500, not a diversified global equity portfolio.  Third, you don’t participate in 100% of the gains.  They remove dividends from returns and apply a participation rate (reduced rate at which you “participate” in the change in index value).  There is also a cap limiting your annual gain.  What is the most troubling feature?  They can actually change the cap and participation rate after you purchase the policy.

Is the FIA a viable product?  Yes.  But FIA’s should be sold as a variation to the traditional fixed annuity product.   They should not be sold as the upside of the stock market without the downside.  They should not be sold as a “free lunch”. 

After further consideration don’t sign me up, but thanks for the steak!  

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