Equity-indexed annuities: Rip-off or bad rap?

by Pop on March 23, 2010

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You can’t fit a square peg into a round hole.

Ragging on equity-indexed annuities is a favorite pastime of the media, financial advisers, and state attorneys-general all over the place. The reason is pretty clear. Ever since equity-indexed annuities were invented, unscrupulous salesmen have pushed the worst versions of them onto seniors who don’t understand their implications. Over time, their sales tactics became tied tight with the product—and something that might have actually had use to some investors became a producto non grata (no idea what the Latin word for “product” is).

Thing is, when you strip away all of the ugliness equity-indexed annuities have brought on, you’re left with an investment vehicle that doesn’t look nearly as bad as the blind criticisms make it out to be. That doesn’t mean they’re right for you. But how about we give equity-indexed annuities a fresh shot to see in what circumstances they might make sense.

I’m getting ahead of myself. Here’s what an equity-indexed annuity is for those unfamiliar.

Striking a deal with an insurance company

At its heart, an equity-indexed annuity is an insurance contract. You fork over an investment to an insurance company, and it promises to grow your money at a certain rate of return. Equity-indexed annuities tie their returns to a stock market index, like the S&P 500. But unlike if you simply invested in the stock market directly, the insurance company promises a minimum rate of return, say 2% or 3%, that you won’t dip below. You won’t lose money.

Obviously, the deal wouldn’t be worth it to the insurance company if that were it. As part of the deal, your return also won’t go above a certain limit. Sometimes, the company gives you a hard cap. For example, you can’t earn more than 7% in a year. Sometimes, the company has you participate in a percentage of the S&P’s return. For example, you’ll get 70% of the return—if the S&P rises 5%, you only get 3.5%. If that weren’t complicated enough, different versions also calculate the return in different ways. Sometimes it’s a simple price change. Sometimes it’s the average of the monthly returns…don’t ask…you’d be forgiven for observing that these are made to be impossible to understand.

And one of the most powerful deterrents to an investment is that you’ll pay a hefty penalty for investing in one of these suckers and withdrawing your money quickly. Most of them have a surrender charge if you withdraw your money within the first three to ten years. And because salesmen often get higher commissions the longer they’re able to lock you in, they push the contracts with the worst penalties. It turns out, some of the sales practices annuities salesmen use are heinous enough to bring down the wrath of lawmakers and Dateline NBC. But just in the interest of giving equity-indexed annuities a more-than-fair shake, let’s set all that aside for a moment. Are they, apart from the tactics, useful products?

The weak criticism of an equity-indexed annuity

Most of the time, when I read criticisms of these things, they focus on a couple, pretty weak arguments. The arguments all stem from the same, false comparison: “Equity-indexed annuities make less money than a balanced portfolio of stocks and bonds.”

Equity-indexed annuities most often don’t include dividends in their computation of the S&P 500′s return. In that way, they won’t perform as well as a simple index fund. I’ve seen some advisers show graphs that show—properly, I might add—that the annuities end up with a smaller return than a stock/bond portfolio over long periods of time.

But both of those arguments are pretty weak. Why? Equity-indexed annuities are a practically no-risk investment. Of course you won’t make as much money as a stock/bond portfolio. A stock/bond portfolio can lose value, whereas this product can’t. You pay for that safety with a lower return.

So in that way, it’s much more fair to compare the returns of equity-index annuities to that of risk-free investments, like CDs, money market accounts, and Treasury bonds. Stacked up against those guys, the returns of many equity-indexed annuities actually don’t look so bad.

One, big caveat: some of these contracts let the insurance company change the returns caps to reflect market conditions, meaning the cap you started with might not be the one you have next year. Not comforting.

The good case against them

Maybe they’re not a bad product in and of themselves. But the question becomes this: How many people should put a significant amount of their retirement savings in an illiquid, risk-free investment? The answer: Not many and maybe no one.

Retirees would benefit from owning a risk-free investment. But they wouldn’t be suited to the 10-year-plus surrender charges that keep them from accessing their money soon.

Young people wouldn’t have to worry about the surrender charges. They have plenty of time to ride those out. But they also wouldn’t be suited to saving a significant amount of their nest eggs tied up in a risk-free investment. Since they’re young, they’re supposed to take risks on the stock market for the higher return it makes possible. Having them invest a lot in an equity-indexed annuity is akin to putting half a 27-year old’s nest egg in Treasury bonds. He’d have to save a helluva a lot of money to make retirement happen that way.

Which is kind of where equity-indexed annuities leave us. Not evil (though maybe salesmen take things too far), but not quite the right fit for anybody.

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{ 12 comments… read them below or add one }

2 Cents March 23, 2010 at 9:14 am

I like the risk-free aspect of these things, but it sounds like that disappears if the insurance company can change the rules on you mid-game. It seems like these might be OK for someone with a very large portfolio who could afford to allocate a portion of their wealth to this type of product – provided they are willing to spend an hour deciphering the fine print.

Ken March 23, 2010 at 9:29 am

I agree with the previous commentor that these are OK as a ‘portion of’ someones portfolio…not the whole enchilada…thanks for taking time to explain an often misunderstood retirement option.

MossySF March 23, 2010 at 12:12 pm

It’s not quite as riskless as a CD. Annuities, GICs are covered by each state’s insurance guaranty fund. Each state has their own limits on coverage and of course. We probably could get what the gap should be between treasuries/FDIC-CDs versus insurance contracts by looking at the credit-default swaps for the states.

Ginger March 23, 2010 at 12:53 pm

The only time I have heard them to be good is if you make a lot of money and are maxing out all you tax deferred vehicles and are saving some in taxable accounts, then you might want to look into an annuity. But again, not good for most people.

Rob Bennett March 24, 2010 at 6:50 am

Retirees would benefit from owning a risk-free investment. But they wouldn’t be suited to the 10-year-plus surrender charges that keep them from accessing their money soon.

I don’t see this as being a dealbreaker (although it is certainly a factor that needs to be taken into consideration). You noted above that it is possible to shop for a 3-year commitment rather than a 10-year commitment. That would make a big difference.

And even a 10-year commitment doesn’t make these of no value to a retiree. If you retire at 65, you might live 30 years. You could finance the first ten years of your retirement with something else and then use the funds accumulating in the 10-years to finance the remaining years of your retirement. Retirees don’t need to have access to all of their money at one time.

I also don’t agree at all with the idea that young people should always be in stocks. Big price drops actually hurt young people more than old people because in a price drop you lose not only the nominal amount of the loss but all compounding returns on that amount for many years to come. Young people have more years ahead of them, so the loss associated with giving up compounding returns is greater for them. I think that young people and old people should invest heavily in stocks when prices are reasonable and avoid them when prices are dangerously high.

Rob

MossySF March 24, 2010 at 2:42 pm

As an extra aside, insurance investments are popular in China because the stock market is just too neurotic. In addition, the fees/hidden costs are comparatively not as bad because there’s no such thing as no-load funds — even index funds will carry a 1% load.

K Smith April 5, 2010 at 11:11 pm

I think your assessment is spot-on. In my experience, when a product or service is marketed with big commissions and high pressure sales tactics – some multi level marketing, time shares, and equity indexed annuities – it is a pretty good indication that the actual numbers of those who will benefit from it are really very small.

EJ April 26, 2010 at 12:58 pm

Question one. What is the one thing that can hurt a retiree more than anything? Loss.

Question two. Doesn’t every study availalbe today indicate the maximum withdrawal rate an investor should use is 4% with adjustments for inflation each year? If a person can use an annuity and access 10% per year, doesn’t that fit the “safe withdrawal” provision?

Question three. Does the tax treatment of an asset help a person in retirement? Less taxes means lower gross withdrawals, which leads to a higher probability of success. Annuities offer tax deferral and an “exclusion ratio” when withdrawing income.

Does anyone understand how index annuities work and where they fit? Index annuities establish rates each year depending on the interest rate environment and the cost of options. In a low interest rate environment with high option costs you will typically see lower caps or participation rates and vice versa. Given today’s environment, if interest rates do start to climb and the market stays volatile, index annuties may provide a perfect middleground.

I am not suggesting that index annuities are the answer. I believe a person should hold equities for long-term investment purposes. It is not a good idea to make periodic withdrawals from an equity portforlio though. Bonds typically fill the role on the other side for withdrawal purposes, but if interest rates do indeed rise, the market value of bonds will decrease. The thing to remember is that stocks and bonds are marketable – not liquid. We do not know what the value of a stock or bond will be later on down the road, but we do know what the value of a fixed annuity or fixed indexed annuity will be. The fixed annuity cannot and should not fit in the same category of a stock. It is a “safe” investment and therefore the comparison should reflect other “safe” investments like CDs, MMs, bonds, and other high quality fixed income investments.

Additionally, actual history is more important than hypotheticals. If you would like see actual historical numbers, visit the following link:

http://fic.wharton.upenn.edu/fic/Policy%20page/RealWorldReturns.pdf

Snwbdrchick October 14, 2010 at 3:23 pm

Or appropriate for someone who is conservative invesstor and is more concerned wtih NOT having volatility, and okay with fair ROR. I am considering putting a chunk of money into one just so I know that part of my retirement monies are not volatile, keeping the other 1/2 in the stock market (scary these days!). Age 44

David Schechter February 18, 2011 at 11:52 am

In my opinion, Fixed Indexed Annuities (FIA’s) — especially those offering bonuses — are the very best investment a retiree can make.

The liquidity issue is a serious one, but most FIA’s permit — after the first anniversary — withdrawals of to 10% of cumulative value in any year.

Second, most FIA’s offer a multiplicity of indices including a fixed interest strategy.

Currently, I always choose to allocate 50% of my investment in the fixed interrest strategy. The remaining 50% I divided between various indices such as the S&P 500 and the NASDAQ 100.

I am earning an 10% bonus on every premium dollar I invest over the course of the first 7 years.

Of course the surrender charge — if I exceed the 10% penalty-free limit — is high. That’s fine with me, the surrender charge needs to be high to recover the bonus and more from those investors who “jump ship.” I think high surrender charges safeguard the interests of those who remain on board for the duration of their contract.

No better investment is available that:
(1) Provides safety of principal;
(2) Provides protection against inflation;
(3) Provides adequate (albeit limited) liquidity;
(4) Provides estate protection.

The case against FIA’s should be dismissed !

Donna Tornoe March 27, 2011 at 4:20 pm

Anyone in CA interested in learning more about Indexed Annuities, email me. I am authorized to sell EIAs. I can certainly explain the participation rate, caps, and anything else you want to know! Like one comment said above, you can split your Annuity between the fixed and the Index. There are several different types. We offer a 50% participation rate with no cap on the Index side and a fixed interest rate on the fixed side. If the S&P is flat based on your index date or point to point, you lose nothing and you gain on the guaranteed amount. If you’re over 59 1/2 you can take out 10% a year of your principal with no tax and no withdrawal charge after the 1st year. There’s also a Convalescent Rider and a Terminal Illness Rider included so if something happens you can access more of your money without penalty. I think its the best vehicle out there to protect your hard-earned money.

Cindy August 5, 2012 at 6:06 pm

I am a young widow and am considering investing in a FIA because of some of the things that make it unwise for others. First, I want to protect the heritage my husband left for my children and not risk it in other ventures. I feel this might be a safe place to invest for the long haul.
Second, my situation is unusual, I am not retirement age but technically I am now retired so I need and desire to be conservative. I feel this is a good way to keep my money from being heavily taxed and I won’t need it for some time. It will be available later. I like the idea that FIA’s may include the Terminal Illness Rider, as I just helped my husband through a 2 year terminal illness and the reality is, one never knows what is right around the corner even though we don’t see it.
Any input on whether I might fit the model of someone who should invest at least part of their portfolio this way?

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