One of the biggest risks an investor faces is running out of money in retirement. In an effort to reduce this risk and generate income, some people choose annuities for their retirement plans. They may be drawn to “guaranteed income” or “guaranteed minimum returns” claiming to provide a retirement free from worry about investments.
But below the surface, annuities are generally complicated investment vehicles. Many insurance agents often don’t fully understand the products they are selling! So it's no surprise that many investors face unexpected costs, complex restrictions and other issues after purchasing their annuities. Moreover, annuities may fail to deliver the simple "safety" they so often promise.
In some cases, annuities may be able to shield you from certain losses, but there might be better ways to limit your risk while still reaching your investment goals. Are annuities right for you? Here are some questions to get you started (click on questions to find answers):
In this article, we’ll provide some background and analysis on some basic annuity misconceptions and potential disadvantages.
Annuities have many different forms and terms, but at their core, annuities are insurance products that provide ongoing payments or income. Three common types of annuities are fixed, variable and indexed annuities.
We believe it’s important for any investor considering any type of annuity as part of a comprehensive financial plan to understand how these insurance products operate. Though guaranteed, an annuity’s return may be much less than traditional investments, like stocks and bonds, over time.
Fixed Indexed annuities—also known as equity-indexed annuities or simply indexed annuities—are common in the insurance industry. But many investors do not understand what they’re buying when they purchase these products.
The name implies equity exposure or market participation. But careful inspection reveals that these products are actually variable interest rate products—products whose interest rates vary over time based on underlying indexes that change periodically. The interest rate is based on a stock market index—like the Dow Jones Industrial Average or S&P 500—but the contract does not hold stocks, bonds or mutual funds.
In addition, various indexing options, rate caps, rate floors and participation rates can erode your long-term return and result in large opportunity costs. Though indexed annuities guarantee a minimum return, maximum returns can be less than the full performance of the underlying index—also called a rate cap. For example, indexed annuities typically subtract a fee from the benchmark’s gain to determine your rate of return—known as “margin,” “spread” or “administrative” fee.
In Exhibit 1, we used a hypothetical indexed annuity with cap of 5%. If purchased with $100,000 in 1994 and held through August 2018, this hypothetical indexed annuity’s returns would have lagged far behind its benchmark index—the S&P 500—by just over $770,000. Downside protection offered by an indexed annuity may not seem very attractive to you when viewed over the long-term. You may also find you want or need more growth than an indexed annuity can provide.
Exhibit 1: Indexed Annuities’ Low-Growth Potential
Source: FactSet as of 9/10/2017. S&P 500 Total Return Index and BAML US Treasury 7-10 Year Total Return Index from 12/31/1993 to 8/31/2018. Hypothetical annuity indexed to the S&P 500 with a 1% floor, 5% cap and 100% participation rate.
Variable annuities are also popular, likely because they offer mutual fund investment options with insurance-related guarantees. But are they a good investment for you?
An often-overlooked detail in today’s variable annuities is the asset allocation restrictions. In order to reduce risk to the insurer, some contracts limit the amount of investment that can be made in equity subaccounts. Some may even require a minimum investment in money market funds, which are generally as safe as cash, so additional insurance on those assets shouldn’t be necessary.
But if the lifetime income still sounds more appealing than the growth opportunity elsewhere, we believe it’s still important to keep digging—to learn how these contracts have performed in the past and assess the real cost of their protection. Variable annuity fees can take a much greater toll than expected, and most annuities don’t have a single flat rate fee. Many have complex fees that, together, can add up to several percent and thousands of dollars annually. Consider the fees of an average variable annuity with one common rider:
In the above example, the hypothetical variable annuity fees with one rider could amount to 3.44% annually!
Investing should be primarily about achieving your long-term investing goals. While you may prefer to avoid downside volatility and market fluctuations in the short-term, variable annuity fees can make it difficult to achieve the long-term growth you may need in order to achieve your long-term goals. It’s important to understand an annuity contract’s fees, payout structure and growth potential before purchasing one of these products.
Annuities are complex products and can be expensive and potentially illiquid. Too often, insurance salesmen and brokers sell these products to investors because it earns them a higher commission from the sponsoring insurance company. If this describes your experience with annuities, we may be able to help. Fisher Investments has helped thousands of investors learn more about their investment choices, and we have dedicated professionals who may be able to help you. Contact us to discuss your options with a qualified Fisher Investments representative or download our Annuity Insights guide to learn more about annuities and Fisher Investments’ services today!