Equity Indexed Annuities: Trendy, But Are They the Right Fit?

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.

An Annuity Overview: Types and Comparison

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:

• Accumulation period. You make a payment or a series of payments, and the insurance company invests the proceeds, thus allowing the investment to grow over time.
• Annuitization. At some time, as spelled out in the contract, your annuity investment is converted into a series of periodic payments, for the rest of your life (or a fixed period, depending on the annuity’s structure). At annuitization, your investment usually becomes the property of the insurer, and recovering your money in a manner other than the periodic payments set out in its contract can be difficult and expensive (or even downright impossible). 

Though there are thousands of different annuities on the market, they mostly come in three basic types:

• A fixed annuity periodically pays you a set amount based on the amount accumulated and an actuarial assessment of your life expectancy. As the insurer controls how the money is invested (usually into fixed-income instruments), they generally have fewer fees but a low rate of return.
• A variable annuity also gives you periodic payments, but the amount varies based on the performance of the investments made with your deposits. So if, for example, the market goes down, your eventual payment value may go down as well, and your principal is fully at risk. To counter this possibility, many variable annuities offer a guarantee that your payment will not go below a certain amount, but this usually comes as a rider (additional contract terms, available for an additional fee). The costs associated with variable annuities can be significant because the investor controls where the variable annuity’s investments are made. This makes any guarantees much riskier for the insurer, who cannot anticipate the risks the investor is likely to take on.
• An equity indexed annuity combines the features of fixed and variable annuities. Generally they offer a minimum rate of return similar to a fixed annuity, but this rate may increase based on the performance of an established stock market index to which it is tied.

For more on understanding annuities in general, we encourage you to read our guide, "Annuity Insights: Nine Questions Every Investor Should Ask."

Equity-Indexed Annuities: Comfort, Fit, Value

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.

Some Questions You Should Ask

• Will you get lifetime payments? Most annuities offer lifetime payments; some do not, but rather structure payments over a fixed number of years. In other words, it’s possible to find an annuity you’ll outlive, negating annuity’s strongest potential benefit.
• Do dividends and interest pass through? It's important to know how the annuity treats dividends and interest. What type of account is the annuity held in: taxable or tax-deferred? Are dividends and interest passed through to the investor as a taxable event? If so, they may increase what you owe Uncle Sam each year, effectively adding another cost that reduces your investment’s return.
• What are its beneficiary benefits? Some annuities are structured to pass along remaining benefits to your heirs, but others are not. How these benefits pass can have serious tax implications that can be complex to navigate, so you may want to hire a tax or estate planner to sort it out (which you could consider an unofficial annuity fee).
• What level of inflation protection is available? Some annuity payments grow over time to account for inflation, but some do not. Normally, equity indexed annuities rely on their variable return to make up the difference between their minimum rate and inflation; but as markets move up or down, these returns can be unreliable. Many companies also offer riders that reduce early payments while increasing them later to address this issue; but this also increases your mortality risk—the likelihood you’ll die before recovering the full value of your annuity.
• What features are standard and which are additional riders with associated fees? "Annuity rider" is a general term for any optional features not in the main annuity contract, but added to it through another contract. Many popular features in annuities are actually structured as riders (guaranteed minimum withdrawals, guaranteed protection against loss, etc.), and each comes with an extra fee. It’s important to know what you’re getting and what you’re paying for to evaluate whether you’re being offered a reasonable price for the annuity’s protection.
• How is the equity index return calculated? As we mentioned, equity indexed annuities often pass on only a portion, such as 70%, of the index’s returns—called the participation rate. So, if the index tied to your annuity is up, say, 10% last year, you would only get 7%, in our example. Even that might not happen, as the annuities may also include upside caps. If your annuity has an annual cap of 12% and the index goes up 20%, even if your participation rate is 100%, you'll get no more than 12%. This is often calculated before the annuity’s fees are factored in; so even these theoretical 7% or 12% figures might be further watered down.

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.  

Compare Indexed Annuities with Alternatives

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.