The pitch is very appealing to fiscally conservative seniors. Earn up to 8% on your investment with a guarantee not to lose money. Sounds too good to pass up, doesn't it?
Welcome to the world of indexed annuities. These financial vehicles are sold by insurance companies and target the risk-averse investor or retiree. Indexed annuities collect your investment money as a premium and guarantee you a positive return over a given period of time. The insurance company invests the money and pays out returns that track an index, such as the S&P 500. However, the actual return that you receive will be determined by several factors.
- Cap – The upper end of returns will be capped at a certain percentage over a time period, such as 3% monthly or 8% annually. While you are guaranteed against loss, that means you are also guaranteed of not reaping the full benefits of a strong market.
- Participation Rate – The amount of the index's return credited to the annuity, usually over 80%. In other words, a 9% gain in the market at 90% participation rate returns 8.1% — unless a cap drops the rate even lower.
- Spread – Also called asset fees or margins, this is effectively the insurance company's gain on your investment. A spread fee of 3% means that you receive 5% of an 8% index gain (assuming that your cap is above 5%).
Other factors and fee structures can lower your overall return, such as riders to add a lifetime income component. There may be other factors included, so check the information on any plan carefully to verify how returns are calculated.
True, you are guaranteed not to lose money as long as the insurance company is solvent. Should that happen, losses are covered by whatever state guaranty fund exists, according to their rules. Typically, principal is returned, but interest may not be covered.
Since annuities are insurance products, they are regulated through state insurance commissions and do not have the oversight of the Securities and Exchange Commission (SEC). As a result, indexed annuities are less transparent and the fees and costs are harder to track.
Insurance companies can alter the cap, participation rate, or spread to maintain profitability — even after you have signed the contract and are locked into a time frame. Some annuities allow a partial withdrawal annually, but most impose significant penalties on withdrawing the funds early.
This leads to two major disadvantages of indexed annuities:
- Comparison to the Market – The market beats indexed annuities over almost any significant time period. Fidelity compiled a chart comparing S&P 500 indexed annuities to the ten-year rolling averages of the S&P 500 from 1926-2013. With the exception of a slight dip in 1964, only two periods in that time gave an advantage to annuities — the Great Depression and the dot-com bubble at the turn of the century.
Had you invested in a fund tracking the same index, you would likely have a more transparent fee structure, no cap, and the benefits of dividends (indexes do not include dividends). You can also sell your holdings at any time. You do, however, run the risk of losses.
- Liquidity – Cash-based conservative investments provide poorer return but greater liquidity as well as stability. Indexed annuities are trying to hit the sweet spot of higher returns at the expense of liquidity. Sometimes indexed annuities hit that spot, but that depends on market performance and the insurance company's profitability margin.
In general, indexed annuities are profitable for the insurance companies, otherwise they would not be offered. An indexed annuity does what it says it does — it guarantees no loss of money as long as you keep the funds in the account up to the surrender period — but it is very costly to remove funds early and it is not easy to calculate how much you are paying for the no-loss guarantee. In many market times, you would be better off with other investments.
If you are extremely risk-averse and uninterested in financial issues, an indexed annuity may work for you. However, at least do yourself the favor of comparing typical annuity returns with an average CD or money market fund. These types of conservative investments may give you returns approaching annuities in a down market while allowing you to retain easier (and less costly) access to your money. Ask an independent source other than the insurance salesman, such as a financial planner, before you sign a contract.