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Proceed cautiously with

Equity indexed annuities

Benny and I used to work together back in my banking days. With retirement close on his horizon, he stopped by for a chat over a cup of coffee.

As we caught up, Benny admitted that he never really understood much about the investment world. The myriad of products easily overwhelmed him. However, he said that one product had gotten his attention.

It was an equity index annuity. Benny excitedly came to life as he repeated much of the boilerplate given to him by a broker he knew.

I listened for a while and then asked Benny whether the volatility of the stock market still worried him. He quickly replied "Yes" and then added that this was one reason he favored the annuity: the guarantees.

I asked him whether he had read the prospectus. Benny's head cocked to one side, and he sarcastically said, "Do you really want me to read 500 pages of legalese?" No, I said. However, if you pull them up online, you can strategically look for certain items by doing a controlled search.

In general, I look for things such as fees and commissions. However, there are many other aspects worth evaluating such as mortality, administrative and investment expenses. Additionally, for each additional benefit or "rider," there is an associated fee.

There are also surrender fees - meaning that if you take your money out early, they will charge you to withdraw funds. Some surrender penalty periods are up to 15 years in length.

As we analyzed the annuity, a few things quickly came to light. Benny thought the annuity would be a good way to earn the long-term average of the stock market, or about 10 percent per year with downside protection via the guarantee.

It was an interesting point. Since the beginning of 1933, the stock market has averaged about 11 percent per year - better than Benny anticipated. However, I asked Benny how much of that return came from appreciation and how much from dividends?

Benny said he didn't know - but didn't understand why it mattered.

As I scrolled through the prospectus, I uncovered that the annuity owner only received the appreciation of the underlying index - but not the dividends.

Benny's face tensed up. He asked, "How much can that be?"

Out of the 11 percent per year, four points, or 36 percent, came from dividends. I could tell that Benny was struggling to understand, so we put it in more tangible terms.

If you invest $100,000 and earn 11 percent per year for 25 years, you'll end up with more than $1.35 million. Benny liked that answer.

However, if you invest the same amount but don't receive the dividend, you'll only end up with $540,000. Benny quickly exclaimed, "That's an $800,000 difference!" He was clearly shocked that a little dividend could make such a big difference. Furthermore, he recognized that this was before factoring in all the fees.

To make the point even more dramatically, I asked Benny what he thought would happen if we encountered another time frame like the 2000s in which the market went nowhere. Benny realized the impact of dividends would be huge in a flat market.

In fact, from 1999 through 2012, the market delivered a slim 3.4 percent per year - but 2.4 percentage points, or 70 percent of the total return, came from dividends.

Recognizing the sales pitch was quite different than the potential outcome, Benny then asked a better question: "Why would a broker sell me this if it delivers so little performance?"

Often in life, if you follow the money, you identify people's motivations. Many annuities pay commissions as high as 13 percent. That's a hefty incentive.

As we finished our coffee, Benny left, realizing the need for more questions. Undeniably, he recognized that many investment products, especially annuities, are very complicated.

Given this, the more questions investors ask, the better informed they can be. Quite possibly, it might be an $800,000 question.

Dave Sather is a Victoria certified financial planner and owner of Sather Financial Group. His column, Money Matters, publishes every other week.


Originally published January 28, 2014 at 3:48 p.m. Victoria Advocate