This Annuity Sounds Perfect - Here's Why It's a Trick

If it sounds too good to be true, it probably is.

pen laying on paper contract

I’ve warned you many, many times about so many annuities and why you should stay away from them.

But there are new types of annuities (or at least ways to pitch them) popping up all the time. And that means I keep getting new questions.

Recently, a really smart guy called into my radio show. He’s been listening for years and knows how I feel about annuities and understands the reasons why, but he was pitched one that actually sounds great.

It was described to him as a No-Cap Annuity that would give him a 10% match. That means that if he deposits $500,000 his contract would be for $550,000. That’s $50,000 free dollars! What could possibly go wrong?

I’ll get to that, but first I should explain annuities and how they work. There are three basic types:

  1. Fixed Annuities: These are similar to a bank CD. You invest a certain amount and are guaranteed a specific rate of return (typically 1% or 2%); this rate is guaranteed for a certain period of time, such as 1, 3, or 5 years.
  2. Variable Annuity: The return is based on the returns of the financial markets (stocks, bonds, gold, etc.). No one knows how those investments will perform which is why these annuities are called “variable.”
  3. Equity Indexed Annuity: This is what the caller was describing. The return is indexed, or based on, the returns earned by the stock market. If stock prices rise, you make money, but – and here’s the marketing pitch – if the market goes down you’re guaranteed to not lose money.  

Back to the caller. He was pitched a “no-cap” Equity Indexed Annuity. What is a cap? Simple: many EIAs limit the amount of gain you can get per year. Say your cap is 5%. If the market rises 5%, you get 5%.

But if the market earns more than 5%, you still only get 5%. Since the average gain since 1926, according to Ibbotson Associates, is 10%, that 5% cap can cost you a lot of money. 

Thus, my caller was excited that his EIA was “no-cap” – meaning he’d get the market’s return, no matter how high it might be. Sounds great, right?

Not necessarily.

That’s because there’s more fine print to consider. What is the EIA’s “participation rate”? This is another way the annuity marketer determines how much gain to give you each year.

If your participation rate is 100%, you’ll get all the gain up to the cap. But if your participation rate is only 60%, you get only 60% of the gain up to the cap. If the market rises 6%, you’d be credited with only 3.6% in this case. So even though there might not be a cap, you still might not be fully benefiting from the market’s gains.

Annuities that have both caps and participation rates hit you with double-whammies. And there’s more. Remember that bonus they promised to give him that would turn his half a mil into $550,000? Well, to actually receive that bonus, most contracts require that your money remain invested for at least 10 years. So really it’s not a 10% bonus; it’s really a 1% bonus per year for 10 years.

And if you liquidate your annuity within the 10-year period, you lose the entire bonus – even if you were there for nine years, you’d lose the entire bonus, not just 10% of it. 

We’re not done. There’s also something called a Surrender Fee. When you sell, you might have to pay this fee, which can wipe out all the interest you had been credited since you purchased the product! We’ve seen contracts that charge a surrender fee for 12 years, making it quite possible you’ll incur this charge.

Oh, one other issue: taxes. Annuities aren’t subject to favorable capital gains rates. Instead, they’re taxed as ordinary income. So, even though your return is loosely based on the stock market’s gains, you’re not taxed as though you were invested in the stock market. Instead, you might pay twice as much in taxes as you might have paid had you bought a mutual fund or exchange-traded fund.

Promoters of annuity products can make their products sound slick. Telling you that, “we guarantee you can’t lose any money. If the market goes up, you’ll go up” might make you feel good. But there are often tricks, and now you know them.

Remember, if there’s a dollar sign involved, we can help. Before you make any large decision with your money, talk to someone who thinks about these things every day. We’re here and we’re happy to help.

This material was prepared for informational and/or educational purposes only. Neither Financial Engines Advisors L.L.C (also referred to as Edelman Financial Engines) nor its affiliates offer tax or legal advice. Be sure to consult with a qualified tax or legal professional regarding the best options for your particular circumstances.