Indexed Annuities Cap Gains, Obscure Fees as Sellers Earn Trip to Disney

When Helen Siswein, a retired teacher, heard about an investment that might earn 8 percent a year and never lose money, she was sold.

“I thought, ‘Boy, if the market surges I could make a lot,’” said Siswein, 82. She put about $1 million into four different annuities linked to stock-market indexes in July 2003 on the advice of an insurance agent who came to her former home in Bucks County, Pennsylvania, after her husband died.

Siswein said the agent didn’t tell her she was locking up most of her money until her 87th birthday or that there were caps on how much she could earn. It cost Siswein fees of as much as 15 percent of her account balances to get out of the investments five years later, the contracts show. She says one annuity earned an average of about 3 percent a year after the penalty was subtracted, while the index it tracked, the Standard & Poor’s 500 Index, returned 6.3 percent including dividends.

Investors such as Siswein are buying more equity-indexed annuities, contracts that earn money based on the performance of stock indexes and don’t decline in value if held to maturity. While that protection may be attractive to investors who saw the S&P 500 plunge 38 percent in 2008, the contracts’ complex terms and embedded fees make them unlikely to perform as well as expected, said Kent Smetters, a professor of insurance at the University of Pennsylvania’s Wharton School.

“These contracts have really high hidden fees,” said Smetters, a former U.S. Treasury Department economic policy official. “That’s why they’re terrible ideas for older people even though they’re peddled to them.”

Record Sales

Insurers led by Allianz SE and Aviva Plc sold a record $8.7 billion of indexed annuities in the third quarter, up 16 percent from a year earlier, according to AnnuitySpecs.com, a market research company. The contracts generally earn nothing when stocks fall and include caps on returns that insurers can change at will. Salespeople are paid commissions as high as 12 percent, and some are rewarded with free trips to Disney World. Unlike the fees on mutual funds, those costs aren’t disclosed.

Indexed annuities are part of a boom in structured products, opaque investments pitched as a way for conservative investors to earn higher yields. As insurance agents sell more complex annuities, stockbrokers across the country are pushing structured certificates of deposit and notes, which are similar derivatives-based investments created by Wall Street banks. Sales of structured notes rose to a record $49.5 billion in 2010, according to data compiled by Bloomberg.

“The pure psychology of downside protection with upside potential sells really well,” said Smetters. “These products are all very complicated. The problem is, they’re not transparent.”

Use of Derivatives

Salespeople typically downplay the complexity of indexed annuities and their long lock-up periods, said Barbara Roper, director of investor protection for the Consumer Federation of America, a Washington-based lobbying group. The contracts are “one of the most abusively sold products on the market today,” said Roper.

Insurers create the annuities using derivatives, financial contracts whose value is derived from stocks, bonds and commodities. While the policies guarantee principal if held to term, they have withdrawal penalties that may last for more than 10 years. The dividends paid by stocks in the index generally aren’t counted toward the annuities’ returns. Buyers can convert the contracts into a lifetime stream of income at maturity. Most don’t, said Smetters.

Downside Protection

“You will never get all of the upside” of the stock market because returns are capped, said Eric Thomes, senior vice president of sales at Allianz Life Insurance Company of North America in Minneapolis, the largest seller in the U.S. “You also don’t need to worry about the downside, and with what happened in 2008, this type of benefit will no doubt interest a lot of people.”

Low yields on federally insured bank CDs are helping sales of indexed annuities, said Wendy Waugaman, chief executive officer of American Equity Investment Life Holding Co., based in West Des Moines, Iowa.

“It’s really easy to see why they’re so popular in today’s environment,” said Waugaman. Investors also are buying because they’re “afraid of market risk,” said Waugaman. American Equity is the third-largest seller of indexed annuities, according to AnnuitySpecs, based in Des Moines, Iowa.

Disney World

The company is offering agents that sell at least $2.5 million of its products in the 12 months ending June 30, 2011, a trip to the Walt Disney World resort in Orlando, Florida. Agents must sell an additional $600,000 of annuities to bring a child. The trip is to the firm’s annual convention, a standard industry practice, said Waugaman.

Insurers who sell indexed annuities buy derivatives from banks to cover the contracts’ guarantees, making the business less risky than selling other investments with a guaranteed minimum return. In 2008, insurers lost money on variable annuities with similar guarantees when the stock market plummeted. Hartford Financial Services Group Inc. wrote down the value of a variable-annuity business by $274 million and Prudential Financial Inc. also recorded a loss.

Indexed annuities tend to underperform a lower-risk strategy of rolling over CDs, “because of the high cost embedded in these things,” said William Reichenstein, professor of investments at Baylor University in Waco, Texas.

CDs Are Better

For example, an insurer may take $100 from a customer and invest $94.33 of that in bonds and keep $2, said Reichenstein, who has analyzed several indexed-annuity contracts. With that remaining $3.67, the company buys a portfolio of derivatives linked to the S&P 500 that will give investors some, though not all, of the index’s returns.

Even with interest rates near record lows, CDs may still do better than the annuities because insurers will have to reduce caps on returns to maintain profitability, Reichenstein said.

“They’re not playing Santa Claus,” said Reichenstein. Insurers must earn enough over time to recoup what they pay upfront to agents or brokers who sell the annuities, cutting into returns to investors, he said. Commissions range from 1.5 percent to 12 percent, according to AnnuitySpecs.

The opacity of the products’ fees and complexity of the return calculations makes it impossible for investors to figure out if they’re getting a good deal, said Glenn Daily, a fee-only insurance consultant based in New York.

“You’re paying the insurance company to set up and manage a portfolio of fixed-income securities and derivatives,” he said. “You don’t have transparency.”

Surrenders, Withdrawals

Contracts prevent canceling, or surrendering, for a refund of the account balance without a penalty for a set period that ranges from 3 years to 16 years, AnnuitySpecs data show. However, most contracts do permit 10 percent penalty-free withdrawals annually, according to AnnuitySpecs. Owners may incur a 10 percent charge from the Internal Revenue Service if distributions are made before age 59 1/2 because the earnings are tax-deferred.

Siswein, the retired teacher, bought her indexed annuities from Robert Calamunci of Monmouth, New Jersey. Calamunci, now an accountant, said he no longer sells the products and declined to comment further. Siswein said she needed financial advice after her husband’s death left her with more assets to manage and Calamunci convinced her to put about $250,000 each into four indexed annuities.

Her Contract

One of the indexed annuities Siswein bought, called FlexDex Bonus, was issued by Allianz Life accompanied by a 23-page packet explaining the terms. The contract required Siswein, who was 75 at the time, to tie up most of her money until she turned 87 or pay withdrawal penalties of as much as 15 percent. She canceled her policy because of lower returns than she expected and the limited access to her funds, which she says she didn’t understand when she bought it.

Earnings were based on a portion of the average monthly performance of the S&P 500 without dividends as calculated from her contract’s anniversary on July 14 to the same date the following year. The S&P 500, with dividends reinvested, returned 35 percent from July 14, 2003, to July 13, 2008, compared with about 15 percent Siswein made over the same time period including the surrender charge, according to Carolyn Walder, president of Lifetime Wealth Planning and Management in National Harbor, Maryland, and Alexandria, Virginia, who now advises Siswein.

Total Return

“Up until 2008 the market had gone up dramatically,” said Walder. “She should have made a lot more money during that time.”

Without the surrender charge, an investor like Siswein may have had a total return of nearly 30 percent for five years, or almost 6 percent a year, said Laurie Bauer, a spokeswoman for Allianz Life, in an e-mail. Bauer said she couldn’t comment on Siswein’s contract because Siswein wouldn’t sign a release. Holders of indexed annuity contracts were protected against market declines like 2008 and lost no principal or previously credited interest, Bauer said.

Siswein said she joined a class action suit against Allianz originally filed in 2005 alleging misleading sales of indexed annuities. Allianz Life denies the allegations of the case, said Bauer.

Indexed annuities have caps on returns and other terms that insurers may change annually at their discretion. Siswein’s contract with Allianz Life, for example, had a cap of 8 percent on how much she could receive from the S&P’s performance in 2003 when she bought it that was lowered to 6 percent for the policy year beginning July 2008, according to her statements.

Altering the caps allows insurers to change how much they spend on the derivatives that fund the payouts, said FBL Financial Group Inc., based in West Des Moines, Iowa, in a Sept. 30 regulatory filing.

‘Additional Spreads’

“Quite frankly, each and every quarter, we’ve started taking additional spreads,” which helped increase the company’s profits, said Chief Financial Officer James Brannen, during an Aug. 6 conference call with analysts. Brannen referred questions to Kathleen Till Stange, vice president of investor relations, who declined to comment.

Vincent Chiodo, a 68-year-old retired firefighter, said he invested $113,000 in an indexed annuity issued by an FBL unit called EquiTrust Life Insurance Co. after meeting an agent at a free dinner seminar at Bonefish Grill near his home in Palmetto, Florida. Dissatisfied with his returns, he said it cost him about 20 percent in fees in July to get out of the contract after four years. FBL declined to comment on Chiodo’s policy.

‘Parades’ for Annuities

Rick Stgeorge, the Sarasota, Florida-based agent who sold Chiodo the annuity, said he explained the withdrawal fees and that Chiodo made a mistake by terminating the contract when he did. Most of his clients are happy with their returns and tax benefits, he said.

Indexed annuities allow investors to defer taxes, though earnings when withdrawn are taxed as ordinary income. Capital gains from stock sales are generally taxed at a lower rate.

“There should be parades for indexed annuities,” said Stgeorge, who spells his last name as one word. Annuities earn between 3 percent and 8 percent with “no risk,” Stgeorge said.

Ron Smythe, former chief executive officer of Meineke Car Care Centers Inc. based in Charlotte, North Carolina, said he started moving money into indexed annuities about a year ago. He bought a contract issued by Allianz Life from Stgeorge because of the principal protection and potential for higher yields than other annuities. Smythe, 76, who’s retired and living in Longboat Key, Florida, said he’s unconcerned about the surrender charges for early withdrawal because he said he’s holding them “for the long range.”

Not Strict Enough

Unlike the stocks they track, fixed-indexed annuities generally aren’t subject to U.S. securities laws and are regulated by state insurance departments. An amendment introduced by Iowa Senator Tom Harkin to the Dodd-Frank financial overhaul law passed by Congress in July blocked the U.S. Securities and Exchange Commission from overseeing the market.

State insurance regulations aren’t strict enough to prevent salespeople from taking advantage of the elderly with indexed annuities, said Roper of the Consumer Federation, who lobbied for the products to be regulated by the SEC.

In Iowa, companies and individuals licensed to sell annuities have to gather information from buyers such as their finances and age to ensure the contract is suitable, said Jim Mumford, first deputy commissioner and securities administrator for the state’s insurance division. Agents who offer indexed- annuities must also take at least an additional four hours of training on the products, Mumford said.

No FDIC Guarantee

Annuities aren’t guaranteed by the Federal Deposit Insurance Corp. Insurers agree to cover losses if a company fails, up to a limit that varies by state. An investor in Florida, for example, is covered up to $250,000 or $300,000 per company, said William Falck, executive director of the state’s Life & Health Insurance Guaranty Association. While the principal on an indexed annuity contract may be reimbursed by the state guaranty fund, the interest may not, Falck said.

MetLife Inc. and Prudential, the two largest U.S. insurers, don’t offer indexed annuities. MetLife allows its agents to sell indexed annuities from third parties, Patrick Connor, a spokesman for the New York-based company, said.

TIAA-CREF, the retirement company that manages more than $400 billion, also doesn’t offer them. “Very few people understand what the product is,” said Dan Keady, director of financial planning for the New York-based company.

To contact the reporters on this story: Zeke Faux in New York zfaux@bloomberg.net.

Margaret Collins in New York at mcollins45@bloomberg.net.

To contact the editors responsible for this story: Rick Levinson at rlevinson2@bloomberg.net. Alan Goldstein at agoldstein5@bloomberg.net

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