ERROLD F. MOODY JR.

August 8, 2007

WMI- Consultancy

1901 Avenue of the Stars

Century City, CA 90067

RE: Steve Smith, EIA Annuities

Dear Mr. Xxx,

Pursuant to your request and authorization, I have prepared a report analysing the usefulness and efficiency of a Indexed Annuity for Mr. Steve Smith. The commentary also includes the fiduciary duty of the agent and company in providing a product that could never work as intended. In short, Mr. Smith had stated a need for income in 10 years from inception of the product. But the product had a 14 surrender period- certainly limiting his withdrawals to a substantial surrender penalty. Additionally, and an absolute breach of duty, was the fact that Smith had clearly stated that he needed to use $400,000 of his assets in a year's period. But he was induced to invest ALL his funds into the EIA and then withdraw the $400,000 a year later. As an instructor in all types of investments and insurance for over 30 years, one does NOT invest funds for such a short period of time.

I first need to put my comments into perspective and, in order to do so, it is necessary to review part of my background. Of particular relevance to acting as an expert in regards to broker/adviser knowledge is the fact that for about 15 years, I taught most of the securities licensing courses for the two major instructional firms in the United States- Dearborn and Securities Training Corp (STC). Such licensing training included the series 4, 6, 7, 8, 22, 24, 27, 52, 63 and more. But it must be noted that the material presented was solely focused on passing the exam- not in providing the fundamentals of investing (diversification, alpha, beta, standard deviation, correlation, etc.) because they are not tested. And if they are not tested, they are not taught. The requirement as a fiduciary mandates either the proper application of this necessary knowledge or at least the employment of one who does. However, and a key element for this review is that insurance agents have no mandatory education in securities analysis. They are not provided any insight to risk and reward of the market. Additionally, neither entities are required to know how to use a financial calculator. This is mandatory in establishing the present and future value of assets and in order to do any type of retirement planning.

I have also taught investments and financial planning for universities and authored the only course on Securities Application, "Practical Investment Theory and Application" accepted for continuing education by the California State Bar. I have taught investing, real estate and financial planning courses for the University of California (subjects required to become a CFP) and have specifically focused on the real life practical applications of such fundamentals. My web site contains numerous articles I authored on investing, planning, real estate, ethics, insurance (and all other planning issues) with extensive linking to other professional sites on the subjects. I have acted as an arbitrator and continue to provide expert testimony on all financial subjects.

As a more specific reference to this situation is the review of the insurance and annuity applications. My background in this area includes being one of the approximately 33 Life and Disability Insurance Analysts in California. Additionally, I have taught insurance continuing education courses for over six years encompassing life insurance, annuities, taxation, estate planning, ethics, pension planning, disability insurance, financial planning, retirement planning (including defined benefit and defined contribution plans) and more. In regards to this area, it needs to be noted that while investments tend to have hundreds of articles, books and web sites analyzing same (Morningstar being the most obvious), insurance is far from being so "transparent". Returns, commissions, charges, fees, usage, suitability and almost everything else requires an analysis far beyond the norm in order to figure out what is going on. There are no books or treatise identifying the correctness of various products. The industry generally allows the sale of various products without any oversight until well after the fact. That said, a fiduciary duty is still due- the products must work as intended. It is important to recognize this duty, more so with this obligation to retirement plans.

Lastly, I have written extensively in the field and McGraw Hill contacted me to write a book on planning. No Nonsense Finance was published by them in 2004 and references a real life emphasis to all areas of planning.

In short, the combined education, licenses and other background furnishes the knowledge and experience to examine the above reports in regards to investment and insurance applications.

Equity Indexed Annuities (EIA)

It is necessary to first develop an overview of EIAs in general before analyzing Smith's specific annuity. And to do that, if is next necessary to review the standard fixed annuity, then a variable annuity and then how the industry has massaged the two into a form of"investment" that is designed to provide a return hopefully greater than that of a similar fixed bond investment over the same time period. The point is that I have addressed ‘bonds' as the leading focus for EIAs, not the stock market. While true that the return is based on some movement of the market, it is not true that the investor receives the entire return. It is not true that an investor gets stock market returns without the stock market risk. Therein lies the fallacy of the predominant marketing by almost all the firms selling these. Risk and return almost always work in positive correlation- the lower the risk, the lower the projected return. Additionally, EIA annuities are generally long term investments (5-6 years minimum up to 15 years or more) and are not acceptable for most elderly. (There are shorter term EIAs even for just one year, but there is little historical documentation and they will not be considered for this report). That is yet another reason why the NASD et al have come down hard on their use for those over 60/65 years of age.

The products have significant surrender penalties for early withdrawal prior to maturity.

This, therefore, limits their use to any type of an emergency fund. (It is true that one can take out certain funds, but to do so causes some major adjustments in the returns).

Standard Annuity

The accumulation phase of an annuity is the time in which money is put in and left to grow. For example, one is 50 years of age and puts $25,000 into an annuity with the intent to let it grow until some subsequent date- normally after retirement. The funds grow tax deferred until payout. One may also put in various payments over time.

While simple on its face, annuities are distinctly involved if for no other than you rarely know the returns you will get year after year. The companies generally give you a guaranteed return for the first year (up to perhaps five) but you have no idea what subsequent years will bring. Even the potential of reviewing past rates is no absolute reflection of new rates to the future (though history can be a gauge to the general focus of the company in providing new rates as regards current economics. The statement is necessary to address the fact that, while some companies may issue new rates directly reflective of new bonds, some companies lump investors into pools of money that may reflect all monies the company is currently investing while others may put new investors into a different subpool. And not only must one know the pools but attain the history of same. Most companies are loathe to provide such information to anyone, investors or agents alike.)

Of course one must also recognize that direct bonds rates also change and attempts to gauge what returns might also be possible is also difficult. While it is possible to get stated returns for each bond, most bonds come with various call dates for such issues and one may be forced to redeem the bonds before maturity and start all over again.

The key that is marketed for annuities is the tax deferred buildup. It can have merit if one is comparing returns to a fully taxable account in a CD or mutual fund. For this section, I will address CDs as the outside investment. The simple chart shows a tax deferred annuity versus a taxable CD.

$25,000 for 25 years, Tax deferred @ 5% Taxable at 5%/30% tax bracket

84,658* 59,080

This is what is presented in many cases. The asterisk is something akin to "please see your tax adviser for further details". The detail is that the entire gain of $59,658 in the non taxable account ($84,658- $25,000) will be taxed at ordinary income tax rates. If one uses the same 30% tax bracket at the time of disposition, there is $41,760 left for a total amount of $66,760.

When comparing the two, the annuity appears to shine. ($66,760 versus $59,080). On it face, perhaps. But if the funds were withdraw all at once, the total of all ordinary income would probably put the taxpayer in a higher tax bracket (the greater the income, the higher the tax bracket. This will become material for Smith during retirement). So there is less than what the numbers present. (Numbers are rounded, based on annual compounding and more to simply compare apples to apples.)

However, the above comparison is not apples to apples. If you bought individual bonds, you get the full yield. If you buy an annuity, there is a reduction for fees of commissions, and return (profit spread) to the insurance company. Being somewhat generous, I opted to show just a .25% reduction for the annuity.

$25,000 for 25 years, Tax deferred @ 5% return Taxable at 5.25%/30% tax bracket.

84,658 61,629

66,760 AFTER TAX

Now the final numbers after tax are the $66,760 for the tax deferred strategy and $61,629 for the taxable account. For simplistic purposes, you made an additional $5,000 in the annuity but it took 25 years to do so. You were impacted by various restrictions including penalties if the funds were removed prior to 59 ½.

However I once again point out the lesser yield on the annuity once the guarantee period is finished. I have reviewed hundreds of policies over the years and the consistency by insurance companies is to provide consumers a much lower yield than what is currently being promoted to new investors. The extra yield to newer customers must be an offset to the existing ones. The insurance company must maintain a profit spread and cannot offer more- or even as much as it makes. An inducement of high initial returns has to be accounted for someplace. If the expenses of the company are maintained, then the returns to other investors must be lowered. Of course, a consumer seeing this is apt to move the assets elsewhere. But it is simply a fact that annuity owners seldom look at new rates and even more seldom make changes to new companies (passive paralysis) unless an agent makes the "suggestion" via a 1035 exchange to a newer company with higher rates. (And the cycle begins once again.) The point is that real life indicates that the tax deferred yields after the guarantee period would drop the return to something far less than that of the taxable CD or bond. For example, if the tax deferred yield actually averaged 4.75%- not an unreasonable given the above example the total return is $79,761 and the after tax return is $63,332. That's 1,700 increase of the CD in 25 years (63,332 - 61,629). That is illogical in the extreme for that period of time, the surrender charges and the taxes for distributions before 59 ½.

$25,000 for 25 years 4.75% tax 5.25% taxable/30% tax bracket

79,761

61,629

63,332

One other problem- rarely addressed in the media. I have ‘assumed' that the investor is getting the best yield from the agent. Not necessarily so. Commissions may be varied depending on what the agent wants as his share. But if the commissions utilized are high, the return to the investor drops. For example, an agent can accept a 4% commission for a 5% investor annuity return. But the marketing material (solely presented to the agent) may show that an agent can get a 5% commission for a 4.5% return (50 basis points less). There are no statistics to show what is actually happening, but the overall marketing for such ‘opportunities' clearly create an "absolute conflict of interest". I think the great tendency is for the lower yield and the higher commission. To date, no material I have read or seen from any Department of Insurance requires a duty to inform the public of the variations. And while not all companies may do this, it is a fact that it started around 2000 and is proliferating. I have not dropped the rates any lower for this example- just making clear the real world of returns and commissions.

There are a number of separate commentaries, adjustments and restrictions that could be applied, but suffice to say the added burden to the annuity are not particularly very valid given the term, inconsistencies of yields and more- certainly considering roughly a third of one's lifetime in order to get the difference in the examples above. Bond yields must also be recognized as not being certain and adjust with the economy. But annuities, save for the initial guaranteed terms, historically pay less than bonds.

Lastly one must also address any bonuses offered with annuities- and EIA companies market these as extensively as regular annuities. Bonuses can be beneficial to the investor if used correctly. Most bonuses are inducements for an initial purchase. A 6% one year rate seems so much higher than a current acceptable 4.75%. The problem is that the bulk of companies lower rates ‘extensively' after that to make up for the higher one year return with the result that the overall return over the surrender period is less than a firm not offering the bonus. That said, some companies offer a bonus with the intent that you stay with the policy for its entire term. Companies buy blocks of bonds and if consumers/investors are swayed by agents to change annuities at a whim (many times due to the bonuses identified above), it makes the ability to make a constant profit more unattainable. However, one must review the past history of the company to see which effort they are making (assuming one is able to get the figures- as stated, a very difficult task if even possible).

To be fair, a short term fixed annuity can be beneficial. Assume an annuity would pay 6% for five years guaranteed. If economic interest rates were falling, it is a way to lock in a nice yield for a period of time. Such time frame lockup is generally not available with CDs and the returns would be assuredly less than the annuity rates. Of course, that assumes that the investor already has a CD (even an IRA) where the use makes sense. Simply charging into an annuity for the higher return where no annuity was really needed for retirement and none was already there is not good planning/investing.

Variable Annuities

Most notable, regardless of the various implications of fees, etc., is that the overall return for fixed annuities is effectively nothing different than what can be attained on bonds. They can't be because that is what the companies buy. That's the focus for almost all annuity companies prior to mid 1980's. But once the equity markets started to surge- with specific reference to mutual funds- and started to make returns far beyond the bond yields (remember that bond yields were very high in the early 80's and outdistanced some equity positions. Then FED chairman Volcker instituted policies which dropped bond rates dramatically). Insurance companies decided to include mutual funds to make up yet another variation of the returns inside an annuity. The inclusion of funds did provide a returns greater than that of bonds- though not as great as the market itself. The difference is simple- the extra fees within the policy dragged down any return possible.

Here is another simple format to address the problem. Assume a variable annuity with charges of 1.25% for management fees and another $1.25% for the management fee of the annuity. You are now looking at a minimum 2.50% reduction in overall returns. Consider a 10% historical return with .25% management fee for the index.

$25,000 for 25 years 8.50% Variable 9.75% Net Index 500

$192,000 256,000

The $64,000 difference is significant. Of course, the market returns are no guarantee but the historical positive deviation must give investors food for thought.

There is an additional major caveat to the annuity. While no taxes are applied during accumulation, the gains over the $25,000 basis are taxed as ordinary income when retrieved. It is not unreasonable to use a 30% tax bracket. (If the entire account was cashed out at one time, the bracket would be higher still.)

The index will have some annual taxation but minimal at best. With only a (roughly) 2% dividend annually and a low 5%- 7% turnover rate (index funds have turnovers only when a company moves in and out of the index), the taxable amounts are low. The gross amount at termination will have only a 15% long term capital gain (based on current taxation). It is not my intent for this report to go into more detail on variable annuities. Suffice to say, the inherent fees reduce the return by a substantial margin.

The caveat to the stock market per se is the risk of loss. There is volatility and that was most recently shown by 2000- 2002 where the market dropped by 44%+ overall (including dividends) . The market has rebounded nicely till late with returns of 28.41%, 10.70%, 4.85% and 15.63% through the end of 2006. (2007 is in a state of flux)

1. Arithmetic Average Stocks T Bills T bonds Stocks - T.Bills Stocks - T.Bonds

1928-2006 11.77% 3.90% 5.20% 7.87% 6.57%

1966-2006 11.61% 6.03% 7.48% 5.57% 4.13%

1996-2006 11.06% 4.15% 5.92% 6.91% 5.14%

Risk Premium

Geometric Average Stocks - T.Bills Stocks - T.Bonds

1928-2006 9.86% 3.85% 4.95% 6.01% 4.91%

1966-2006 10.34% 6.00% 7.08% 4.34% 3.25%

1996-2006 9.56% 4.14% 5.67% 5.42% 3.90%

But consumers feel extremely uncomfortable with market swings and, everything else being equal, would opt for no losses at all. Hence the beginning of the Equity Indexed Annuities which started in 1995. The caveat is if you are unwilling to accept volatility, you must be "willing" to accept a lower return. Unfortunately, that is not what is objectively presented to investors.

Equity Indexed Annuities

As identified above, regular fixed annuities provide bond like returns (though somewhat less than direct bonds with fees and offsets). The variable annuities can provide significantly higher returns IF the historical averages hold up (which still must be adjusted for fees). Even so, the 2000- 2002 time frame not only devastates investors financially but, most importantly, emotionally. So the industry developed a program that supposedly/apparently/hopefully would offer a return greater than bonds- based on the returns of the market (various indexes)- while also guaranteeing that there would also be no loss to the principal (variations now apply). The concept is relatively simple. The insurance company takes the bulk of the funds and invests in bonds. That's where the guarantee comes from for, say, on 85% to 100% of the invested funds (more like 85% to 90% today) The rest is invested in options on the market (S&P 500, S&P: 400, Dow Jones, Russell indexes, NASDAQ 100, etc.). If the market does produce an acceptable return over the term selected for the investment (say 10 years), then the investor gets a ‘piece of the index action". I repeat, a piece of the action of the index- not all of it. The key- to be explained later- is what that piece will actually produce.

On the other hand, if the securities indexes produce no return over the entire term, then the company pays a guaranteed return on the funds invested (though most generally only about 85%- 90% of said amount after the early 2000s. The return might be 2% or 3% (guarantees have steadily dropped in the last few years as overall economic rates have dropped. In the late 1990s, it was not uncommon to see a 4% guarantee on 100% of the funds invested.) Pay particular note that it is not the fact that the market dropped or stayed flat in a singular year. It is the fact that the market did not return an overall return equal to the guarantee over the entire period. That an index does not produce anything in a singular year means nothing until the entire term is completed.

Unfortunately, the determination of what a product might produce is based on a myriad of actors evidenced in the policy makeup. Unfortunately again, almost every policy is unique to itself. As one actuary said, once you have reviewed one EIA, that is exactly what you have done. Reviewed ONE.

These are very complicated products which few understand. There are a myriad of initial moving parts that can also change AFTER the original purchase. My initial experience was confusion on the ultimate gain an investor might anticipate.

The marketing was focused on the various indexes and how one could not lose any money (guarantees at that time were for the entire amount invested) while at the same time getting stock market returns. That seemed impossible. It was impossible. After attending several seminars designed to explore the inner workings, it became clear that the returns had to be bond-like. My impression was that an EIA would return yields greater than that of fixed annuities about 65% to 80% of the time; would produce the same as a fixed annuity about 15% to 20% of the time and return less than a fixed annuity 5% to 10% of the time. These averages were to reflect the economics of the past years as well as the different types of index makeups that existed at that time.

Regulation

The EIAs have gone through a lot of changes- most notably the use of many more indexes (instead of just the S&P 500) Unfortunately, more does not mean better. It created a hodgepodge of indexes (S&P 400, NASD, Russell and more) that were sold primarily by insurance agents that had no background in securities.

The SEC commentary on EIAs is located at http://www.sec.gov/investor/pubs/equityidxannuity.htm.

The NASD commentary on EIAs is located at http://www.finra.org/InvestorInformation/InvestorAlerts/AnnuitiesandInsurance/Equity-IndexedAnnuities-AComplexChoice/P010614

The NAIC (National Association of Insurance Commissioners) commentary on EIAs is located at http://www.naic.org/documents/committees_lhatf_actuarial_guideline_variable_annuities.doc

The NASAA (North American Association of State Administrators ) commentary is located at http://www.nasaa.org/Issues___Answers/Legislative_Activity/Testimony/4999.cfm

While the guarantee by the insurance company did indicate the product falls, technically, within the purview of the state insurance departments, the sale of the products- with the almost absolute focus (my emphasis) on the returns of the stock market- led most securities department (the NASD and SEC specifically) to try to force the product into dual registration. The consensus is that the states will impose that these are securities if for no other reason that agents are selling them as such. And they have done that because previous marketing (as well as current use) has focused on the "ability" to get a stock market return with no risk. I repeat, these can only be compared to bonds, not stock.

Indexes

As indicated, the EIAs started with the S&P 500 index as the sole reference. Since that time, more and more have been added. The Dow Jones, NASDAQ 100, Lehman U.S. Aggregate, Average multiple index, S&P 400, Russell 2000, DJ Euro Stoxx 50 and more.

Indexing Method

The indexing method means the approach used to measure the amount of change, if any, in the index. Some of the most common indexing methods include annual reset (ratcheting), high-water mark, point-to-point, monthly, performance triggered and more. Point to point is the most common. These are explained more fully below.

Participation Rate

The participation rate decides how much of the increase in the index(es) will be used to calculate index-linked interest. For example, if the calculated change in the index is 8% and the participation rate is 80%, the index-linked interest rate for your annuity will be 6.4% (8% x 80% = 6.4%). A company may set a different participation rate for newly issued annuities as often as each day. Therefore, the initial participation rate in your annuity will depend on when it is issued by the company. The company usually guarantees the participation rate for a specific period (from one year to the entire term). When that period is over, the company sets a new participation rate for the next period. Some annuities guarantee that the participation rate will never be set lower than a specified minimum or higher than a specified maximum.

The problem for some annuities is that the participation rate for some companies may be changed unilaterally AFTER the first period. This makes it extremely difficult to try and project returns in the future (a difficult venture in itself no matter if the rate stayed constant). It is not a statement that the company is doing it inappropriately. If an annuity uses an annual reset, it is also going out into the marketplace the following year and buying another option on the index. The costs may be more or less than the previous year depending on a number of issues- the economy, volatility and more.

While it is also true that a pure index is also moving due to a myriad of factors as well, the various changes in participation rates, caps, and margins (see below) for EIAs make the analysis even more complicated. I doubt few in the industry know how they work. I doubt that there is but a handful of consumers that know what they were really offered (annuities and insurance are sold, not bought).

Cap Rate or Cap

Some annuities may put an upper limit, or cap, on the index-linked interest rate. This is the maximum rate of interest the annuity will earn. In the example given above, if the contract has a 6% cap rate, 6%, and not 6.4%, would be credited. Not all annuities have a cap rate.

Floor on Equity Index-Linked Interest

The floor is the minimum index-linked interest rate you will earn. A 2% floor assures that even if the index decreases in value, the index-linked interest that you earn will be zero and not negative. Note however that the floor references the entire term- not just one year.

For clarification- if the index went down in one year, the return for that year would be zero- you do not have negative years. But let's say that out of 10 years, nine were negative. In the least year, the market grew 40%. The average for 10 years is 4% per year. You do not get 2% each year when the market declined. Your final return is the average for the 10 years compared to the guaranteed amount if it all went bad for the entire term.

Averaging

In some annuities, the average of an index's value is used rather than the actual value of the index on a specified date. The index averaging may occur at the beginning, the end, or throughout the entire term of the annuity.

Margin/Spread/Administrative Fee

In some annuities, the index-linked interest rate is computed by subtracting a specific percentage from any calculated change in the index. This percentage, sometimes referred to as the "margin," "spread," or "administrative fee," might be instead of, or in addition to, a participation rate. For example, if the calculated change in the index is 10%, your annuity might specify that 2.25% will be subtracted from the rate to determine the interest rate credited. In this example, the rate would be 7.75% (10% - 2.25% = 7.75%). In this example, the company subtracts the percentage only if the change in the index produces a positive interest rate.

It is also important to note that many, if not most, annuities will figure returns without the use of the participation rates or margin spreads and then leave an asterick on the computer number. We'll say the number was 12% and may reflect a very good return for the EIA year. However, the asterick may indicate a 3% margin bringing to 9%. A 25% difference in return is significant but most consumers rarely read the document completely and are swayed by a number that is ‘accurate' in its form but very misleading as well.

HOW DO THE COMMON INDEXING METHODS DIFFER?

Annual Reset

Index-linked interest, if any, is determined each year by comparing the index value at the end of the contract year with the index value at the start of the contract year. Interest is added to your annuity each year during the term.

For example, assume the index was 1000 at the beginning of year 1. At the end of the year, it was 1200. The EIA index was now set to 1200 and no matter what happened in subsequent years, it could not fall below 1200 no matter the loss in the market.

However, when you have resets, you must examine the caps and margins that are invariably present.

High-Water Mark

The index-linked interest, if any, is decided by looking at the index value at various points during the term, usually the annual anniversaries of the date you bought the annuity. The interest is based on the difference between the highest index value and the index value at the start of the term. Interest is added to your annuity at the end of the term.

For example, during the 10 year term, the index hit a high on one day of 2000 but ended the entire term at 1500. The high water mark would be 2000.

Caution is noted however form the caveat above. Are there any margins, caps or other deductions that will drop the overall return.

Point-to-Point

The index-linked interest, if any, is based on the difference between the index value at the end of the term and the index value at the start of the term. Interest is added to your annuity at the end of the term.

As an example, assume the index for one year hit a high of 2000 in July but then went down to 1200 at the end. The point to point would be the 1000 at the beginning and 1200 at the end. Due to such volatility, the high water mark might be valuable on its face- just remember the caps, margins et al do not make the computation so simplistic.

Here is another brief overview.

WHAT ARE SOME OF THE ADVANTAGES AND DISADVANTAGES OF DIFFERENT INDEXING METHODS?

Generally, annuities offer preset combinations of indexing features. You may have to make trade-offs to get features you want in an annuity. This means the annuity you choose may also have some features you don't want.

Advantages Disadvantages

Annual Reset

Since the interest earned is "locked in" annually and the index value is "reset" at the end of each year, future decreases in the index will not affect the interest you have already earned. Therefore, your annuity using the annual reset method may credit more interest than annuities using other methods when the index fluctuates up and down often during the term. This design is more likely than others to give you access to index-linked interest before the term ends. Your annuity's participation rate may change each year and generally will be lower than that of other indexing methods. Also, an annual reset design may use a cap or averaging to limit the total amount of interest you might earn each year.

High-Water Mark

Since interest is calculated using the highest value of the index on a contract anniversary during the term, this design may credit higher interest than some other designs if the index reaches a high point early or in the middle of the term, then drops off at the end of the term. Interest is not credited until the end of the term. In some annuities, if you surrender your annuity before the end of the term, you may not get index-linked interest for that term. In other annuities, you may receive index-linked interest, based on the highest anniversary value to date and the annuity's vesting schedule. Also, contracts with this design may have a lower participation rate than annuities using other designs or may use a cap to limit the total amount of interest you might earn.

Point-to-Point

Since interest cannot be calculated before the end of the term, use of this design may permit a higher participation rate than annuities using other designs. Since interest is not credited until the end of the term, typically six or seven years, you may not be able to get the index-linked interest until the end of the term.

WHAT IS THE IMPACT OF SOME OTHER PRODUCT FEATURES?

Cap on Interest Earned

While a cap limits the amount of interest you might earn each year, annuities with this feature may have other product features you want, such as annual interest crediting or the ability to take partial withdrawals. Also, annuities that have a cap may have a higher participation rate.

Averaging

Averaging at the beginning of a term protects you from buying your annuity at a high point, which would reduce the amount of interest you might earn. Averaging at the end of the term protects you against severe declines in the index and losing index-linked interest as a result. On the other hand, averaging may reduce the amount of index-linked interest you earn when the index rises either near the start or at the end of the term.

Participation Rate

The participation rate may vary greatly from one annuity to another and from time to time within a particular annuity. Therefore, it is important for you to know how your annuity's participation rate works with the indexing method. A high participation rate may be offset by other features, such as averaging, or a point-to-point indexing method. On the other hand, an insurance company may offset a lower participation rate by also offering a feature such as an annual reset indexing method.

Dividends

In order to validate returns when comparing ‘apples to apples', it is necessary to include the dividends that are available on a pure index fund. A return on the S&P 500 includes the dividends that are being earned and invested back into the fund for continuing gains. While a taxable account must address the reduction for such reinvestment, the taxation at 15% is not a hindrance. The dividends for the S&P 500 are now 2%+; the Dow Jones is 2.34%; NASDAQ (which primarily features growth) is 0.5%, Russell 2000 at 1.17%; S&P 400 at 1.25%+ . Dividends for most stocks were higher in the past but have lowered since the 1990s.

While some pundits have indicated that the dividends are a small part of the overall return, think about this. If you have a 10% return for one year in the S&P 500, you have about 20% that is made up of the dividends. That is not a small matter. Per Business Week, "reinvested dividends have actually contributed more than 40% of the S&P 500's total return since 1929. What's more, the S&P 500 dividend yield averaged nearly 4% in all years since the mid-1930s and averaged nearly 6% during the 1940s." (The 40% number reflects compounding.)

Since the EIAs do NOT include dividends, an adjustment must be made for those who direct monies into mutual funds. Phrased slightly differently, depending on your allocation of EIAs, the returns will be an average of about 1.5% currently less than a comparable index fund.

Asset Allocation

One of the marketing elements to the use of EIAs is the avoidance of asset allocation of various indexes with various correlations and so on. EIA marketers suggest that since the EIA cannot lose, the EIA can substitute for professional management. If that be so, then why are there now so many different indexes all based on something different- small cap, large cap, tech and so on? (Initial EIAs only dealt with the S&P 500) However due to this proliferation and the mixes suggested in the purchase, professional management is necessary at the initial point as well as later on. That is because the caps spreads and participation rates are all changing annually and require at least as extensive effort as those for mutual funds.

Admittedly, the use of various mutual funds does require not only an initial direction but continuing management over time.

The issue in dealing with allocation is whether the investor has sufficient funds to hire an outside entity for continual review. For investments of less than $100,000/$200,000, an EIA might be preferable simply because there is no need for management of downside positions. The investor will get some bond like returns. But the point being is that these people were not equity investors to begin with.

However, when the amounts get larger- certainly above $500,000- an investor needs to address the issue of professional management- not only for the initial allocation but also for changes in economics. Of course the cost must be addressed. As for EIAs, an adviser is really adding a fee for a bond fund. You simply cannot add much of a fee since bonds only earn limited returns overall. For equity funds, many fees range around 1% or more. From an August Financial Planner's article, "Nearly three-quarters of advisors raised their fees last year, taking a bigger bite of clients' assets in return for increasingly customized services, according to Rydex Advisor Benchmarking. For the first time since 2004, median asset management fees increased—to 1.00%, up from 0.98% in 2005.) Management fees at that level significantly reduce the end appreciation and are generally not valid- and absolutely for bond funds. But there are CFA (Chartered Financial Analysts) services designed for professional review of index funds that can be had for a .25% annual fee. That is more than acceptable.

For the record, I charge between 0.50% and 0.75% for continuing financial planning review- and that includes money management. At the start of the Dotcom debacle in 2000, I avoided putting any more monies into equities. By late 2000, it seemed apparent that the economy was going downhill (a recession was indentified in early 2001) and opted to remove almost all equities over to bonds. My point is that it is possible to avoid most of the pitfalls of a 1973/74 and 2000/2002 with enough research. An investor must accept market corrections- the 10% to 15% adjustments as time goes on. We are seeing that now in 2007. But if the economics show a recession or similar (consider the inverted yield curve in 1999 and 2000), it is possible to direct investments to a better, less risky position. It's not market timing. It's not a guarantee. But it is what professional management can do.

Financial Planning

The use of any product requires far more than a simplistic comment about risk, losses, etc. Few advisers have much of any background in the area and tend to let the computer dictate the allocations and uses. Financial planning is needed for many consumers/investors to determine what they need to do for the future. It is not what they want to do, what they have done in the past, certainly not what a neighbor suggests nor what is offered at a seminar providing a free lunch or dinner (though extremely successful).

I will note for the record that anyone who suggests they can advise on money must have the personal capability with a financial calculator. If not, the investor is invariably being sold a product by an agent who has little idea how money works.

Smith Analysis

It was necessary to give the above overview of an Equity Indexed Annuity, not so much for your benefit per se, but so I could address specific elements of your annuities.

Liquidity

You were induced to invest $400,000 where you indicated that it would need to be withdrawn within a year.

This is categorically wrong. No investment is made for short term purposes. In such cases, you use a CD or similar cash alternatives. You avoid all the volatility of the marketplace whether in the market or in a circuitous product as an EIA. You avoid added formulas in complicated products to offset the withdrawal. And you also avoid the 10% penalty before 59 ½ (as applicable). I note from "Equity Indexed Annuities", page 30, ".....if you anticipate needing large withdrawals from an EIA during the surrender period, then an EIA is unsuitable for you." And, "very simply, if you will not have sufficient liquidity to meet your liquidity needs outside of the EIA, then the EIA is unsuitable for you and you should stick with cash and its equivalents even if their return is lower". Further on page 35, "fundamentals, EIAs are only suitable for people who will not need liquidity or withdrawals during the contract period. EIAs should, therefore never be sold to or purchased by anybody who knows that they will need to access their principal before the contract period ends".

Lastly on page 36, "EIAs are absolutely not suitable for those who anticipate the need to access their principals prior to the annuity payout. The reason is that EIAs are typically illiquid, and even when they do allow some limited liquidity, they are usually inefficient if early withdrawals of principal are made. So you should never (emphasis author) rely on accessing your principal in an EIA prior to its payout date."

I have emphasized and reemphasized the issue. It certainly is what I have taught and it is verified by others. The point is not only is it just wrong, it reflects an attitude, general incompetence and a breach of duty to employ such a strategy. It, almost assuredly, reflects an inconsistent and probably non existent review by your agent of the EIAs that were sold to you.

I have a copy of the agent's card wherein it notes the Wealth Preservation, Accumulation and Transfer. I also note the term "Financial Services". I don't know what that actually means since he is not securities licensed. He cannot offer any alternatives to insurance related products. He cannot offer commentary on index investments, securities, mutual funds et al since he is not licensed to sell them. He is restricted to insurance and annuity products. So that's what he sold. And it had to be the sale that enticed him since he was going to get a commission on the $400,000 he could NOT put into the EIA.

Then we have the issue of the CSA designation. I have commented in my work on the numerable designations that generally mean nothing. This is one of them. Two major insurance firms disallowed the CSA designation term since it was almost solely a marketing designation with little factual essence. The NY Times noted article, "Certified Senior Adviser- (NY Times, July 2007) "He paid $1,095 for a correspondence course, then took a multiple-choice exam with questions like, "Marketing can best be described as:" (The answer: "The process or technique of promoting the sale or distribution of a product or service.") Like more than 18,700 other applicants since 1997, he passed"

Insurance companies, eager for sales representatives, embraced such monikers as they have thousands of other newly credentialed advisers.

But many of those sales came from steering older Americans into unwise investments, Massachusetts

regulators contend in a lawsuit. Mr. Xxxx is one of tens of thousands of financial advisers working hand-in-hand with insurance companies to market themselves to older Americans using impressive-sounding credentials like "certified elder planning specialist," "registered financial gerontologist," "certified retirement

financial adviser" and "certified senior adviser." Many of these titles can be earned in just a few days from for-profit businesses, and sound similar to established credentials." In short, you got a salesperson who sold you something that would never work as intended.

Retirement Need

This commentary stems from our recent conversation. You indicated that you were going to need about $7,500 per month at retirement (today's dollars). I asked you that because anyone who touts themselves as an "Adviser" has a duty to figure out what you need to do. Not what you would like to do, have done in the past, etc. Certainly not what he would want to do (commission).

By taking the $7,500 and escalating it for inflation for 10 years at 3.5% and at 5%, the amounts would be $10,600 or $12,200 respectively. Assuming a 20 year life span, a 7% overall return on investments (you would still need to keeps funds earning monies during retirement) and a 3.5% inflation rate, the amount of funds you would need at retirement with a $10,600 distribution would be $1,900,000 (rounded).

At a 5% rate of inflation, the amount would be $2,140,000.

At a $12,200 monthly payment, the amounts would be 2,175,000 and $2,460,000.

EIA investment versus retirement needs.

Simply stated, can you get there with $1,000,000 for 10 years at 5.75%. No.

Based on standard calculations your $1,000,000 of investments in 10 years would $1,750,000.

Required "lump sum" at retirement for 20 years. $10,500 monthly

($7,500 at 3.5% inflation) $12,200 monthly

($7,500 at 5% inflation)

Inflation at 3.5%; Investment at 7% $1,900,000 2,175,000

Inflation at 5%; Investment at 7% 2,175,000 2,460,000

$1,000,000 at 5.75% 1,750,000 growth leaves a deficit of $150,000 to $425,000 1,750,000 growth leaves a deficit of $425,000 to $710,000.

A professional adviser had to inform you of these deficits. If you wished have sufficient funds for the perceived retirement, a return of about 7.25% is necessary.

Alternative Investments/index funds

I understand that you were told you could get the benefit of a stock market return without the stock market risk. Cannot happen. While true that you can reduce volatility overall with an EIA, you also reduce return to less than the market given any reasonable period of time. The return on equities is indicated below. These include dividend reinvestment.

1928-2006 11.77%

1966-2006 11.61%

1996-2006 11.06%

The appendix also shows the back testing on EIAs for 10 year periods. Note the returns are about 5.75%- pretty much in line with my previous analysis and commentary about overall bond returns. (Also note the lack of dividends which would have made the returns about 1.5% more.)

For this discussion, I am reducing the equity return by .25% for management. Again for simplicities sake, I will use an average 11% return for the market and with the subtraction of the .25% fee yields a 10.75% net return. I will then reduce this even further for the annual minimal taxation to 10.5%. Note that this is an after tax annual return.

At this point, there is roughly a 5.00% difference in returns between the potential for an EIA versus an index fund. That is considerable. More emphatically, it will make a huge difference in ultimate appreciation.

Assume you had put your $1,000,000 into the market at 10.5% for the 10 year period. That would have equal $2,715,000. Therefore, instead of a deficit, there would have been an excess. In such case, it may have been possible to reduce the exposure to equities as desired. But at least there was room to "negotiate" rather than being left with insufficient funds.

$1,000,000 invested for 10 years EIA at 5.75% Index fund at 10.5%

$1,750,000 $2,715,000

Taxes

The analysis so far has dealt with numbers without tax considerations. I have shown there is a deficiency with EIAs as compared to an index fund. But that is not all. Of the $10,500 removed monthly from the EIA- say $126,000 annually- all would be taxed as ordinary income until the $1,000,000 mark (your basis) had been met. The $126,000 at a most conservative 30% bracket would net $88,200.

As for the index fund, I have shown an increase of $1,000,000 to, for the above example of $2,715,000. This gain is NOT taxed at the ordinary tax rate but at capital gains rates. Of the $126,000 received, $46,000 would be a return of your original contribution (original basis) while the $79,600 of appreciation would be taxed at long term capital gains rates of 15%. That is a tax of $12,000 (rounded) leaving a net of $114,000.

More importantly is if you wanted $126,000 AFTER TAX (the only way such an analysis can be structured), you would need to take out $210,000 (assuming a combined 40% tax bracket state and federal) in order to net the $126,000. You would use up your nest egg very quickly and circumvent most of your retirement.

This is an absolutely crucial issue. The EIA will provide about $1,750,000. That shows a $750,000 gain. But in 3.5 years when you retire, you will have to take out the entire gain to pay for your retirement since you are losing so much in ordinary income tax. Annuity companies tend to use the "whole number" in identify gains. Then they put an asterisk next to see and say, ‘see your tax adviser". In essence, the whole numbers are true but completely distort the end result. One could say that the EIA has guarantees that the market cannot provide. Fine. But if you are going to get less money over time- and in your case insufficient monies for retirement as well as ordinary income tax on the gain- what's the point of the effort. You simply will not have enough funds for retirement. As such, I certainly have avoided addressing monies you might leave to heirs. It is a moot issue.

On the other hand, using the stock portfolio, you would take out about $140,000 which, after capital gins tax, would net the $126,000. Assuming the appreciation for both accounts were the same and you had the same $750,000, it would last 5.35 years- almost two years longer. That's due to the long term capital gains rate being so much lower.

But, statistically, the use of a managed market index account could provide, $2,750,000 as a total or $1,000,000 more than the EIA. Is it guaranteed? No. (Though remember that the EIA does NOT guarantee returns above the 2% or 3% in the contract. I showed that it would provide more than that- 5.75% but it is NOT guaranteed) Anyway, do you have a reasonable chance of obtaining market returns greater than 5.75%. Yes. In such case, the funds will provide over 7 years more of funds for retirement.

There are a myriad of charts that can explore which net amount of the annuity versus the share amount requires what. Suffice to say, look at the simple example. Whatever you take out of the annuity for years and years will be taxed at about 40% (until all the gain is used up). Whatever is take out of the mutual fund index, only the appreciation is taxed at capital gains rates.

$126,000 net of taxes EIA Mutual Fund

$210,000 $140,000

Change the capital gains rate by increasing it and you obviously reduce the difference. But if Congress increases such rate, perhaps so to with ordinary income tax rates.

SUMMARY

I feel it justified to state that not only is there a difference in overall returns, but the subsequent taxation will be an enormous factor in your initial selection of investments. Unfortunately, you were not given this analysis. You were sold a product which will not meet your needs. Additionally, the higher taxation severely restricts its use for you.

There are no guarantees that either product- an EIA or an index fund- will provide the returns identified. But under generally accepted analyses, the EIA can only provide bond like returns- and those gains will be taxed as ordinary income. Based on simply calculations of what you need at retirement, the funds will be insufficient for your retirement.

The index managed account should provide more in 10 years- and under generally accepted analyses, that could be about $1,000,000 more. But all gains will be taxed, under current law, at long term capital gains rates which are 50% to 66% less than ordinary income tax rates.

You were sold the wrong product. You were sold the wrong product by an "adviser" who had a fiduciary duty to do the correct and definitive analysis so you could make an objective choice. But the adviser wasl completely incapable of doing such analysis.

In short, you should not have been sold these policies. The EIA cannot do what you need done.