Buyer beware: A primer on equity-indexed annuities and life settlements

By DIAN VUJOVICH
Special to the Palm Beach Daily News

Insurance products can be a great, and often necessary, expenditure for individuals and investors, never mind some lucky beneficiaries.

The industry offers a dazzling and sometimes confusing array of products and has a powerful lobbying arm. In 2009, for instance, more than $164 million was spent by the lobbying industry in Washington, D.C. So far this year the tally is roughly $44 million, according to OpenSecrets.org.

But not all insurance products, and/or the reps selling them, are scrupulous in their sales practices, disclosures or explanations regarding the intricate details behind the products. It's that underbelly and ugly side of two of this industry's investment products -- equity-indexed annuities and life settlements -- that are the focus of this Buyer Beware series.

'Insurance' exudes comfort

There's something about the word "insurance" that can lead you to believe products in this industry are safe, the risks to owning an insurance-based investment vehicle are minimal and that there will always be some financial reward for you or a beneficiary -- provided you've kept up your end of the deal.

But as with everything else in the financial arena, contracts and fine print always need to be read and thoroughly understood before any monies change hands.

Ask those burned by a product with an insurance wrapper and you're likely to hear they think the only ones making money are insurance companies and their sales people. In the case of equity-indexed annuities (EIAs) and life settlements, there could be some truth to that thinking.

Each has been red-flagged with an Investor Alert from FINRA, the Financial Industry Regulatory Authority, because of the large number of consumer complaints regarding sales scams surrounding them.

Seniors prove easy targets

The scams mostly target seniors and retirees from all income levels.

"Older people are by far the most targeted for investment fraud," says John Gannon, senior vice president of FINRA. "And while the message rings true for anyone, whether they are 21 or 91, in the older audience most people are going through significant life changes, making them more vulnerable to the fraudsters."

Gannon explains that whether it's going from employment to unemployment, entering retirement or experiencing the loss of a spouse, seniors are often faced with having to make a number of decisions for the first time regarding assets they've accumulated throughout their lifetime. That includes things like how to withdraw money from retirement accounts, or use the equity in their homes or the assets in their insurance policies.

"What we've found is many people who are targeted for investment fraud have experienced some kind of negative life event. Whether that's a health or medical issue, a financial issue or problem, those events are what potentially open them up and make them feel that they need to get a higher return," adds Gannon.

Put another way, when people have any financial worries or concerns, whether they are concerns about their personal lives or what's happening within the marketplace, no matter how large or small their estate or asset base, those worries make them more vulnerable and susceptible to making bad, inappropriate or misunderstood investment choices.

Enter equity-indexed annuities.

If equity-indexed annuities could be thoroughly explained in one sentence, they would be and the number of individuals misled by the product would be insignificant. Unfortunately, that's not the case.

"I read an article recently that said you had to have a Ph.D. and then some to really understand what's going on with equity-indexed annuities," says Michael Lavallam of Frank Crystal & Co. in Palm Beach and New York. "There are a number of moving parts in them that even intelligent wealthy individuals need to really be quite astute to follow."

While the bells and whistles to these products may be enticing, Lavallam said three things basically drive investor returns from EIAs. One is the index the product is using and how participation in that index return is calculated.

According to FINRA's Investor Alert on equity-indexed annuities, there are three ways to determine the return of a market index used:

Annual reset or rachet, which compares an index from the beginning to the end of each year.

The high-water-mark method, which looks at the index value and takes the highest of its value and compares it to the index value when the contract began.

The point-to-point method, which compares the change in the index at two discreet points in time.

While all three methods have advantages and disadvantages, it's important to have a clear understanding of the participation rate. That means what percentage of that index return will you, the investor, get? And then, what are all the fees? Just as participation rates vary so do fees charged by insurance companies for things like management and trading expenses. Taken together, all can make a dent in the investment's return.

In an example from Lavallam, if the market index used returned 12 percent, and the investor's participation rate was 50 percent, he would net less than 6 percent because of the additional charges and fees the product carries.

Lavallam's laundry list of things equity-indexed annuity investors need to understand include: Know the index, how returns are calculated, the inherent drivers of the index, costs buried within the contract, the net returns after all fees, and if you need money whether you can make a withdrawal during the year and whether that comes with a penalty. "Indexed annuities are long-term investment based, so if you have to liquidate some of what you've invested, they (insurance companies) may have fees in place for that," he says.

Life settlements

If you decide to sell one of your life insurance policies -- for whatever reason -- and liquidate it for cash, the thing to clearly understand is that, once you cash it in, the money is gone, as are all that policy's promises and guarantees, including any future death benefits.

It's not uncommon for an investment you made in a life insurance policy decades ago to not be a good fit for your current financial needs. Policy premiums may or may not be all paid, the policy worth more than you'd imagined, you're so successful that other investment avenues are more appropriate, and the list goes on. So it's not uncommon to surrender a life policy for many reasons.

Today, there are three ways to get at that loot in a life insurance policy: The first is to die, and the money goes to the policy's beneficiary or beneficiaries; the second, surrender the policy for its cash value; the third, sell the policy to another entity. The latter is referred to as a life settlement; by doing that, two things will happen: You'll receive an amount of cash for selling the policy. You'll transfer ownership of the policy to the purchaser and he will be the recipient of the death benefit when you die.

According to Lavallam, it's large institutions rather than individuals that typically purchase the life settlements, which are then packaged into various investment vehicles.

Selecting a reputable insurance brokerage to handle the transaction is as important as understanding who is purchasing your policy and for how much. The price is driven by your health and life expectancy.

Another fact: This isn't a quick-sale ordeal. In fact, you're not likely to receive cash from that sale in just a few business days. "It's probably going to be a month or more," says Lavallam.

Why so long? It takes time for those buying the policy to check your medical records, calculate life expectancy, calculate the policy's value with respect to how much you ought to be paid, establish commissions, and more.

Three things to consider before considering a life settlement: Why am I doing this, what's my motivation, and what do I hope to get out of it?

"Whether it's an equity-index annuity or a life settlement, people need to be somewhat skeptical and ask themselves whether it's in their best interest to enter into either of those transactions," says Gannon.

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