Posted on February 26, 2015 in ,

Watch Out for Indexed Annuities

People who don’t like risk like a sure thing.  When presented with two options on returns,  the first being a chance to make $8 by giving up $2, or the chance to make $5 by giving up nothing, most people would choose the second option.  This choice involves less risk.  Some people enjoy risk and would take the first option, but we’re not talking about risk-tolerance, we’re talking about people who avoid risk altogether.  Indexed annuities were built to cater to people who are risk-averse rather than those who are risk-tolerant.

In the first part of this series on indexed annuities, we discussed key terms to know when researching these products and what they mean for you.  For this second part, we’ll discuss examples of performance returns and calculations and the risks involved in these products.


Let’s begin by creating an example based on actual market data from 2013.  The S&P 500 index returned 32.33%, including dividends.  We reviewed a sample indexed annuity contract which was held the entire year of 2013.   The monthly return “CAP” (maximum for the month) was 1.5% with a 0% floor.  The year’s performance before fees was only 9.98%.  Why the 22.35% difference?  Because in 9 out of 12 months, the stock market increases were dramatically higher than 1.5% but the annuity didn’t share in the increase.

Let’s compare another indexed annuity to a conservative investment strategy to see what happens. Both start with exactly $100,000.   The conservative investment strategy will consist of $90,000 in a zero-coupon U.S. ten year treasury and $10,000 in the S&P 500 index.  The indexed annuity has a “CAP” of 2.75% annually with a 0% floor (your annual balance never goes down even if the stock market is negative).   At the end of 10 years and after all fees, the ending balance of the annuity is $129,000 versus the conservative investment strategy of $139,000, or $10,000 higher than the annuity.  The “CAP” and other fees on these insurance products hinders the potential gains in your account. This academic study was tracked over 53 various 10-year periods using actual market data.  The results were roughly the same; the conservative strategy beat the annuity by $10,000 each time.


Indexed annuities are being touted to every risk-averse investor.  What most agents don’t explain or understand are the significant surrender fees associated with early withdrawals.  Agents, do however, understand the hefty commissions they earn on these products which often are 8% or higher! Surrender fees for the top selling indexed annuities average 11% in the first year.  Your principal and first year bonuses are protected only if you hold the annuity through the surrender period, which typically is 10 years or more.   In some contracts the first year bonus is voided unless you hold the annuity up to 15 years!   There are also other fees and riders which potentially reduce your return.  They include participation rates, spreads and guaranteed withdrawal rates all of which limit your upside earnings.   Low cost annuity options are available from companies such as Fidelity Investments and Vanguard and allow for distributions without surrender penalties.

Your financial advisor can help you build a comprehensive plan that takes into account your specific needs and objectives.  A plan that includes principal protection, market participation and conservative bonds may be more appropriate than the indexed annuity.


Source: Fidelity Investments

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