Equity indexed annuities—that is, annuities with a rate of return tied to a stock index like the S&P 500—have been gaining in popularity over the last several years.1 And by all outward appearances, many sound like a great deal. Some offer the security of a guaranteed return like a fixed annuity combined with the potential for added gains if the stock market performs well. That mixture of security and opportunity can be quite enticing to retirees anxious about downturns in the market. But, there are many factors you should be aware of and carefully consider before deciding whether one is right for you.
While equity indexed annuities may appear appealing, with guarantees that seem straightforward, some are very complex insurance products. Given the many forms they can take, you should always carefully read an annuity’s terms and thoroughly understand exactly what it’s offering before deciding if it really does fill a need in your needs. You should also consider whether there are any alternatives to annuities that could provide the protection you need.
Before trying to evaluate equity-indexed annuities, it helps to understand annuities as a whole. The concept of an annuity has been around since the Roman Empire, when individuals would make a single, large, upfront payment into an aggregated pool of money, and then receive annual lifetime stipends, or annua, from the pool. Though annuities have grown since these times in terms of size, complexity and the number of types offered, many annuities still have the same two-part structure:
Though there are thousands of different annuities on the market, they mostly come in three basic types:
For more on understanding annuities in general, we encourage you to read our guide, "Annuity Insights: Nine Questions Every Investor Should Ask."
Following the 2008 financial crisis, bond interest rates in the US have been low.2 Meanwhile, the stock market has been on a bull run since March of 2009. With many traditionally “safe” fixed-interest investments providing lower returns, and with stocks being attractive but fears of the recession still fresh, it's no wonder that equity indexed annuities have become popular. Annuity-company claims of providing “market-like returns,” while providing protection against potentially similar recession events, resonate with investors who are still spooked by the markets.
But remember, there is a lot more to consider with annuities than their allure. To determine whether an equity indexed annuity may be right for you, it’s important to carefully consider factors such as comfort, fit and value.
Comfort. Perhaps the most common reason investors turn to annuities is the comfort of that guaranteed lifetime payment stream. While equity indexed annuities offer extra returns based on stock market performance, the participation rates and caps imposed in most contracts severely limit your investment’s potential growth. Additionally, the steep tax penalties and surrender charges that can last a decade or more can make it difficult to exit annuities.
Fit. Some people turn to annuities as a way to get tax-deferred growth, similar to what you can get with a 401(k) plan or an IRA. Unlike 401(k)s and IRAs, there is no limit to how much you can deposit into an annuity each year. But while deposits into an annuity can grow tax-deferred, deposits into an annuity purchased in a taxable account can’t be deducted from current taxes.
But consider the benefits of other account types: the employer match in sponsored plans like 401(k)s can make their rate of return several times that of an annuity and that the ability to write off IRA deposits (up to the limit allowed by your income) can reduce your current tax burden. Given these factors, we believe it’s rarely advantageous to use annuities until you’ve already maximized your investment in these types of accounts. Beyond their financial limitations, annuity taxation can also be complicated—and costly, particularly for heirs. Even getting death benefits may require an added feature—called a riderwith an annual fee of 0.6% of your account value,3 on average.
Value. As we touched on briefly, the growth in equity indexed annuities can fall short—well short in some cases—of investors’ expectations. This isn’t just due to the limitation of how annuity returns are calculated. First come the fees. When you buy an annuity from a broker or insurance agent, the salesperson gets an upfront commission that can go as high as 10%4 or more. In these cases, every dollar you invest suddenly becomes worth 90 cents. Plus, variable and equity indexed annuities tack on annual management fees along with applicable rider costs, all of which can drastically water down your returns over time. You can see in the chart below just how significant these costs can be:
Exhibit 1: Indexed Annuities' low growth potential
Source: FactSet as of 3/31/2016; Hypothetical annuitiy indexed to the S&P 500 with a 1% floor, 5% cap and 100% participation rate.
Remember: There are thousands of annuities out there, each with its own set of unique features, functions, fees and more. This makes it important to thoroughly read and understand the contract of any annuity you’re considering and ask as many questions as you can.
These are just a few of the questions you should seek answers for before purchasing an equity indexed annuity. Sure, annuities may help protect you from outliving your assets, but using them simply to invest more into the stock market or protect yourself against the risk of losses can be inefficient. It’s also important to remember that it’s always the content in an annuity contract that counts, not what you hear from the salesperson. Thoroughly read any documents you receive to make sure that what is in writing matches what you’re told.
Whenever you’re trying to make an apples-to-apples comparison about your investment options, you should consider the performance less applicable fees, relative to the investment’s risk. As you saw in our chart, government bonds or other highly rated debt securities can potentially offer similar or superior performance compared to an annuity over the long term, with essentially the same risk of loss. Plus, by investing directly in the market, you can sidestep many of the fees associated with annuities and enjoy easier access to your assets, should you need it.
If you have questions about your annuity or would like a second opinion on an annuity you're considering, request an appointment with us now. Fisher Investments has Annuity Counselors on staff to help you understand what your annuities offer and how they fare when compared to other retirement investments. We also encourage you to look at our selection of annuity guides for additional insights into these products.
1Source: Insured Retirement Institute, 2016 IRI Fact Book (Washington, DC: IRI, 2016), 5, 7, 79.
2Source: Analysis of daily 10-Year US Treasury Bond rates from 01/02/08–08/07/17, as listed at https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield, showing no rates passed mean rate of 4.58%, calculated using data from Robert Shiller going back to 1871 at http://www.multpl.com/10-year-treasury-rate.
3Source: Insured Retirement Institute, 2011 IRI Fact Book (Washington, DC: IRI, 2011), 36–38, 56.
4Source: Securities and Exchange Commission, Variable Annuities: What You Should Know, https://www.sec.gov/reportspubs/investor-publications/investorpubsvaranntyhtm.html.