Volatility Heightens Annuities' Allure, but Their Pitfalls Remain

With stocks on course for a down and volatile year, it isn’t at all surprising fixed and indexed annuity sales are up. Total annuity sales jumped 25% y/y in Q3—and that was before one of the worst Decembers on record struck.^[i] Given annuity sales results have historically shown a negative correlation to stock returns, it wouldn’t shock us if they spiked again in Q4. But in our view, volatility doesn’t make annuities—particularly deferred annuities—a wise buy. While we can understand their allure during volatility, much of the appeal is, in our view, a costly mirage. Reacting to portfolio swings by locking your hard-earned money in complicated—and typically low returning—products could be a big mistake.

Our beef isn’t with immediate annuities, which convert lump sum contributions to regular payments, well, immediately. For folks with certain needs, goals and circumstances, immediate annuities can be useful longevity insurance. It is a limited universe of people who would materially benefit from this, in our view. But some do.

Deferred annuities, however, are another matter. With deferred annuities, you purchase a contract with an insurance company granting you the option to annuitize (start regular payments) later. In the meantime, your principal is invested, with the aim of having the contract value grow. How it is invested depends on the type of deferred annuity. There are three basic ones—variable, fixed and indexed (alternatively called fixed-indexed and equity-indexed).

Variable annuities generally offer exposure to stocks and bonds through mutual fund-like sub-accounts, enabling them to advertise market-like returns. Yet here, principal moves with the underlying investment. In times of volatility, these are usually out of favor. It is fixed and indexed annuity sales—up 39% in Q3—that often spike with volatility, as the allure of stability attracts buyers.^[ii]  

Fixed annuities generally offer a guaranteed rate of return over a set period, determined by the insurer. Your principal doesn’t fluctuate. You earn a low rate of interest reset at the insurers’ discretion. Indexed annuities imply equity exposure, but they just pay a return that is loosely linked (more on this later) to the annual returns of an index (like the S&P 500). Like fixed annuities, your principal doesn’t fluctuate. But the returns you earn are far from equity-like, as we’ll explain.

Though fixed and indexed annuity principal doesn’t fluctuate, that doesn’t make them a useful hedge against short-term volatility. A fixed annuity is like a more restricted version of a CD. CD-like returns might seem attractive when stocks aren’t doing well. But what happens when the market eventually recovers and you are stuck still earning low returns? What once seemed like a comforting choice could quickly lead to headaches. Shifting back into the market likely won’t be easy. Exit penalties across most annuities can be stiff. Getting out is not simply a matter of calling your bank and forgoing some interest, like a CD. Moreover, there are potentially costly tax considerations and early withdrawal penalties (if you are under 59 ½), depending on your circumstances.

An indexed-linked annuity isn’t better, in our view. Often sold as providing equity market returns with downside protection, the reality doesn’t match the pitch. Indexed annuities pay the insurer by shaving off return. This typically happens in two ways. They might employ a “participation rate,” which stipulates annuity owners receive only a portion of the underlying index’s return. For instance, if the index rises 10% and your participation rate is 60%, you receive only a 6% return. (Which is a very generous hypothetical rate, actually.) The other tool is a “performance cap”—the maximum return you can earn in a specified period (month, quarter or year). Let’s say, hypothetically, you have a 10% capped indexed annuity. In a year like 2013 when the S&P 500 soared 32.4%, you may have earned 10%.^[iii] Or you might have been capped at an average monthly rate, causing you to really miss out, as market returns tend to be quite lumpy, not smooth and even. Finally, most indexed annuities don’t include dividends, which tremendously boost returns. Sometimes participation rates, return caps and price-only returns work in concert, weighing on annuity owners’ results. Ultimately, in our experience, these products tend to also pay CD-like returns.

So if you are considering an annuity as a solution to volatility, ask yourself some questions:

• Did you need equity-like long-term returns for some or all of your portfolio before recent volatility struck?
• If so, is it wise to get out and lock yourself into a low-returning, restrictive contract?
• Do you have a clear understanding of what you are buying and how it will meet the salesperson’s claims?
• Would you be better off taking no action at all and remaining invested as you presently are?

Stocks’ high historical returns include scads of corrections and bear markets. Equity investors don’t really need to dodge negativity to do well. It can be hard to stomach, but a key to investing successfully is not reacting to market moves and volatility. In our experience, many folks unwittingly do great harm to their long-term finances by trying to miss volatility. Buying an annuity is just one example.