As with most annuities, these are complicated products, full of caveats, legalese and financial jargon. Here is a quick guide shining a light on indexed annuities.
Although a relatively recent arrival on the annuity scene, indexed annuities are growing rapidly: Data show annual sales more than doubled from $25 billion to $55 billion from 2007-2015. But despite their apparent popularity, we aren’t sure many buyers have all the information they need before purchasing.
Indexed annuities—sometimes called “equity indexed” or “fixed indexed” annuities—are fixed annuities without guaranteed returns. Here’s how it works: You buy the policy and, during the accumulation phase, the issuer invests the funds at their discretion. They promise your investment can’t decline while in the product, and your returns during accumulation are based on how a selected index (maybe the S&P 500) performs. In addition, there typically aren’t fees for an indexed annuity—a far cry from variable annuities’ steep costs.
Thus far, indexed annuities may sound pretty good. But there are major caveats. You won’t match the underlying index’s return. Not even close. First, your gains are based on a formula in the contract, so you’re getting just a slice of the underlying index’s returns. You are not directly investing in the market or any index. This results in your participation in only a share of the gains—say, half the annual result. Moreover, there are often caps or spreads that limit upside potential. Stock market returns often come in bursts, but an annuity with limits like these likely won’t fully benefit from those bursts. As a result, the owner may not capture the many years stocks soar—from 1926-2015, US stocks rose 20+% in over a third of calendar years.iA performance cap prevents participation in that huge upside, slashing long-term returns.
Second, the index performance used to calculate your payments likely won’t include dividends. This trims gains significantly—since 1926, the S&P 500 total annualized return (including dividends) is 10.0%. Absent dividends, it’s just 5.8%. That 4.2 percentage point gap is gigantic when extrapolated over long time periods. And then there is inflation—historically 3%, it eats away at indexed annuities’ returns even further.
Regret your purchase? Surrender fees strike: These are steep charges assessed on those who pull out of their annuity before the passage of a typically years-long period following purchase. Indexed annuities’ surrender fees are generally the largest of any annuity type, and they cover a longer period of time, post-purchase.
As always, the promise of upside exposure without downside risk is a fairy tale. Indexed annuities are no exception. These aren’t investing’s holy grail, offering equity-like returns and capital preservation. That doesn’t exist. Take care to investigate all hidden risks of an indexed annuity before pulling the trigger. Even for those who don’t need or want equity-like risk, there are simpler, less-costly options. And don’t buy the fear-based sales pitch—the patient investor who sees through myopic market hysteria is more likely to enjoy superior long-term returns.
iSource: Global Financial Data, as of 05/31/2016; S&P 500 Total Return Index from 12/31/1925 – 12/31/2015.