Index Annuities

Index Annuities

by Doyle Ranstrom on Nov 20, 2019

In this new phase of life, with no office to go to, I occasionally have the TV on when working or writing from home. For this reason, I have watched a Tucson morning show, called the "Morning Blend".  The co-hosts, Alex Steiniger and Heather Rowe are entertaining, knowledgeable and make the show enjoyable to watch.  Heather Rowe has sparkle.  I do know what it is or how to define it, but after watching other morning shows, primarily ESPN when working out in the morning, I know sparkle when I see it.  

The show seems to primarily be the hosts interviewing individuals or small groups promoting local events, non-profit organizations and owners or managers of businesses.  The latter seems to be a type of info-commercial and I suspect pays the rent for the show.  

Recently I happened to have the show on while doing some writing and heard the hosts introduce the owner of an investment company and shortly I realized he was selling index annuities which he later confirmed.  Index annuities are a type of fixed annuities, however, they are often promoted as a risk-free option to investing in the stock market. 

The owner of the investment company talked about the risk of the stock market and his strategy can enable investors to participate in stock market gain with no risk.  As would be expected, he made index annuities sound like the perfect investment, high returns, and no risk.  

I wonder how interested consumers would if index annuities were described as follows:

  • The index annuity is a variation of a fixed annuity which was created by insurance companies in the 1990s to compete with CDs and fixed interest rates at that time. 
  • Index annuities are an insurance contract and regulated by state insurance departments. Actual regulations vary by state.  An agent selling the product needs only an insurance license that is issued and regulated by each individual state.  The product is not regulated by the SEC and does not require any type of training, background or securities license.  
  • Index annuities use a very complicated formula to credit interest on a contact.  First of all the index annuity uses call options on an index, for example, the S&P Index.  The contract then may use any or all of the following to calculate the annual return; participation rate, cap rate, and/or margin/spread/asset fee.  
  • Some contracts allow the issuing insurance company to change the system of calculating returns when the contract is in force.  
  • US Securities and Exchange Commission [SEC] published an Investor Bulletin:  Index Annuities in August 2019 which states:  "Indexed annuity contracts commonly allow the insurance company to change these features periodically. Changes can negatively affect your return. Read your contract carefully to determine what changes the insurance company may make to your annuity."  I would suggest anyone interested in investing in an index annuity review the SEC Investor Bulletin:  Index Annuities before so doing.  Since the SEC does not regulate index annuities, I do not know why the SEC issued the bulletin, but if I had to guess, I would guess it was because they were receiving complaints from investors about the product.  
  • Finally, as is pointed out in the Investor Bulletin:  Index Annuities, it is possible to lose money in index annuities. Many contracts have substantial and long surrender charges.  In addition, though many contracts guarantee the principal never decreases below initial investment, some contracts do allow the investor to have a negative return if the index being tracked declines in value.  Again, keep in mind, many contracts allow the insurance company to make changes in the contract and how it calculates the return.    

What about returns.  The guest on the show discussed a brochure with hypothetical returns for index annuities. This is another problem with index annuities, often the sales agents and issuing insurance companies use hypothetical projections of future returns.  There is very little data on actual historical index annuity returns.  I did find one annuity website which reviewed a study that after reviewing actual statements for several index annuity products, found the average return from 2007-2012 to be about 3% with some returns higher and some lower.  

Complicating the return on index annuities is annual statements often show two values; the accumulated value and the surrender value.  The accumulated is the value before surrender charges while surrender value is the amount the contract holder would actually receive if the contract was liquidated at that time.  Investors should use the surrender value in calculating the actual returns

What index annuities are is profitable for agents and insurance companies.  I do not know about the specific product used by the agent on the talk show, but Index annuities are often a high commission product.  One way to estimate the gross commissions on an annuity is to look at the surrender charge and the number of years it lasts.  For example, a 10% surrender charge the first year which declines to zero over ten years may indicate the gross commissions paid to the selling agency of 10% of the initial investment or more.  The actual agent, depending on his/her production, would get a percentage of this.  In this example, $100,000 could generate a gross commission of $10,000.  

In addition, index annuities can be very profitable to the insurance companies as part of their product line.   And let's be clear, there is nothing wrong with making money or a profit.  This is one of the cornerstones of the US economy.  However, the entire process should be reasonable and transparent.  If an investor engages a Registered Investment Company [RIA] to manage his/her portfolio and the RIA charges a flat fee of 1%, the investor knows the amount being deducted from his account for fees.  In fact, the investor signs disclosure forms to this effect.  Index annuity agents and their insurance companies should also disclose the exact amount paid for the marketing of the product including the gross commissions.  

If there was an advertisement that said investors should buy an investment product using options with a complicated method of calculating return which may be changed by the company at any time, the product often has significant and long surrender charges, returns are based on projections while actual historical returns are difficult to find and what data is there seems to indicate returns are similar or lower to other low-risk investments, but the product can pay a high commission to agents and is profitable to insurance companies, I doubt anyone would buy it.  

However, the marketing story is often this is a product that allows the investor to participate in market gains without market risk.  As outlined above, this is at best misleading.  

Let's return to the TV talk show.  The conversation emphasized the risk in the stock market and this product would prevent losing their money in a stock market decline.  First of all, investors do not lose money in a stock market decline.  Investors lose money when the stock market declines and they panic and sell into the decline turning a paper loss into a realized one.  This is one reason the "average investor" historically underperforms stock market average index returns.  A factor contributing to under-performance for the average investor is misleading marketing strategies and scare tactics promoted by agents selling products that encourage investors to make poor investment decisions.  

I am not criticizing the talk show.  The hosts are very talented and do great work.  I am suggesting that consumers need to be very aware and do due diligence before any investment decision.  I would suggest my recent blog on "The difference between a financial planner and financial advisor" would be beneficial when doing due diligence.  

If an investor is concerned about market risk, then they should meet with a Fee-only CFP® like myself to discuss investment objectives, time horizon, desired return, expected return and volatility tolerance.  From there, an asset allocation strategy can be developed which may include a variety of low-risk investments including fixed-rate annuities

Annuities can be a valuable and important part of an overall retirement plan.  Types of annuities include fixed interest with a guaranteed interest rate, variable annuities, and life income annuities which guarantee a monthly payment to the annuitant for as long as the annuitant and/or annuitant and spouse live.  It is important for the consumer to know it is possible to purchase various types of annuities that either do not have or pay commissions to agents or the commissions are very low.  By not paying substantial sales fees to agents and marketing agencies, these products may be more attractive and cost-efficient to consumers.  I recently wrote a blog called Guaranteeing Retirement which may be of interest.  

Finally, spending a small amount to consult a fee-based CFP® may save you thousands or tens of thousands long-term.  

*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets.