There Is No Free Lunch With Indexed Annuities
- Sep 9, 2016
- 5 min read
In the last year, I've had more clients than I can count on one hand ask me about these products. If clients are asking, it means proponents of these products are doing some solid marketing.
If you're not familiar with annuities, here are a few quick highlights:
They are technically insurance products designed to provide income should you live too long. It's kind of the opposite of life insurance.
Two varieties; fixed (low guaranteed rates) & variable (similar the mutual funds in your 401K).
They offer a death benefit. For example, if you invest 100K and your account drops to 50K causing a fatal heart attack, your beneficiaries get the full 100K (assuming you didn't withdraw anything).
They are tax deferred, like your IRA.
They are subject to Last In, First Out (LIFO) tax rules when utilized outside of a retirement account. This means the earnings come out first, subject to ordinary income tax.
They come with all kinds of bells & whistles such as "living benefits". Based on your contribution, they'll apply a growth multiple which future income is based on. This may be helpful if the account value happens to be lower than the living benefit when income is needed.
They are insanely expensive and most investors won't benefit from them most of the time.
How They Work
Indexed annuities are a hybrid annuity, with both a fixed component as well as the opportunity to earn a percentage of what a pre-determined index returns. For example, you'll get at least 1.5% but if the S&P 500 returns 10%, we'll give you 5% (instead of just 1.5%).
Hallelujah, what a perfect investment product! Market type returns with no risk of losing money. The Wall Street Journal says not so fast, and I agree. Like many things in life, if it sounds too good to be true....
So What's The Issue?
There are several issues, in fact.
The first question an investor needs to ask when pitched this product is what's in it for the broker? Is it a trip, a cash reward, a massive commission, company accolades, or maybe all of that? Who do you think pays for all that garbage? You do. It's all baked into the product's fees.
The second question is what index your balance is tied to? Is it the a stock index like the S&P 500 or a more conservative bond index like the Barclays Aggregate Bond? Or, is it tied to some proprietary index you don't understand? Paying high fees (you will) thinking you're getting a "market" return when you're actually tied to a conservative index isn't doing you any growth favors.
Third, what is the "participation" rate? For example, many contracts restrict how much of the index return you'll actually be credited with. If the market is going bananas, you probably won't be enjoying those same bananas.
Next, is there a cap on how much you can earn? Usually, yes. Let's say you get 50% of the S&P 500's return, and the index cranks out a 30% return (happened in 2013). But then you discover you didn't actually get the expected 15%. There was a tiny clause buried in the contract that says your participation rate is capped at 10%. Bugger.
Think we're done? No, there may be a "spread/margin" percentage restriction. It's simple; a stated up-front percent is automatically subtracted from the index return. For example, the spread is 4%, so if the index returns 10%, this fee pulls you back to 6%. Then all the other restrictions can ratchet you down even further.
Do index dividends and interest count? I'll let you guess. When index "income" doesn't count towards your return, it robs you yet another way. A significant portion of an index's total return (the returns we're familiar with) is usually generated by income; in some years as much as 50% of the total return is explained by dividends and interest.
Surrender schedules. These can be all over the place, but most of the schedules I've seen are 7 to 10 years. Unlike most annuities that apply a cost if you transfer your annuity before the surrender period expires, index annuity surrender schedules tend to forfeit your interest earnings. Here's an example from a recent client statement.
If your investment objectives change 5 years into this thing (or you just wise up), you give up half of any of your earnings if there happen to be any. And, do you really want to be tied to any investment product for a decade? Remember The Lost Decade?
There are a few more issues, like fees, which I don't even have time to get into today. I think you get the picture.
A Real Life Example
Last week I reviewed a new client's investment portfolio and found three indexed annuities representing the majority of their retirement investments. Based on their initial investment in 2004, I was able to calculate their total return adjusting for distributions.
From Nov 2004 to Nov 2015 they earned 2.17%, while the S&P 500 returned 4.7%. That may not seem like a huge difference, so let me put it in perspective. A $500,000 investment in the index annuity grew to $633,180. However, earning an extra 2.5% using a large cap equity strategy (and earning the 4.7%) would've brought that balance to $828,673. That's almost a $200,000 difference! Granted, an all stock portfolio would not have been appropriate for these clients, but still, they could have done much better than they actually did.
What Should You Do
After reading this article, you're biased against index annuities. Let's actually call it what it is- more informed. However, annuities in general can be a somewhat useful tool for some investors. Usually those investors are the ones that have maxed out contributions to 401(k)s and IRAs, and possibly looking for another tax deferred account. This is common among high earning households.
If you have an annuity of any type and you're not sure how it works, what it's costing you, and if it's even appropriate for your situation don't be afraid to reach and ask me. It's a painless process that doesn't take long. The worse case scenario is I'll say sorry, this annuity is really expensive but you're locked in for a few more years until the surrender schedule tapers off. There's usually a lot we can do in the meantime to help you reach your goals.
If you're pitched an annuity, especially an indexed annuity as a guaranteed solution to all your portfolio needs just remember, there is no free lunch in the investment world. Read the fine print or ask us to interpret it for you before you buy.
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