I would neither buy or recommend an Index Annuity

I would neither buy for myself or recommend an index annuity.  Before going farther, I believe tax-deferred annuities can be very attractive investment options.  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 following relates to index annuities.  If you wish more in-depth information on index annuities, simply google them and you will find a variety of articles and commentaries.  A good summary is provided by the US Securities and Exchange Commission [SEC] Investor Bulletin:  Index Annuities.  

  • First of all, 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.  
  • They were initially designed in the 1990's to compete with CDs and interest rates at that time. 
  • The index annuity is often promoted as an alternative to investing in the stock market.  In fact, index annuities are very complicated because the return is based on the use of 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 to calculate.  Some contracts allow the issuing insurance company to change the system of calculating returns when the contract is in force.  
  • It is possible to lose money in an index annuity. Generally, index annuities have substantial surrender fees. Over the years, I have seen surrender fees last 10 years and longer.  If the owner has to withdraw the money, there could be a substantial surrender charge.  In addition, some index annuity contracts allow actual losses if the index being tracked loses money.  Contracts may set a floor for the loss which can be less than the investment.  

Again, the SEC Investor Bulletin:  Index Annuities is an excellent summary.  Why did the SEC issue an Investor Bulletin when it is not a product regulated by the SEC?  I do not know, but if I had to guess, the SEC was receiving complaints about the product and decided to issue the Bulletin. 

What about returns?  Index annuities often show hypothetical projected return which provides potential buyers a favorable picture of future returns.  Though difficult to track down, the research which has been done indicates actual historical returns are much lower than the hypothetical projections.  I googled "actual historical returns in index annuities" and was able to find some research.  One study I found reviewed actual statements on several index annuities.  This study indicated an actual average annual return of about 3% from 2007-2012 with a range of higher and 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. 

By comparison, if an investor was invested in a no-load moderate asset allocation fund and decides to sell it, the investment return would be the actual gain or loss when the fund is liquidated. The same is true for index annuities, although agents and insurance companies would have you believe differently.  Going a step farther, if an investor invested $100,000 in a moderate asset allocation model and it declined for a market value of $90,000 that is the same as an index annuity with an initial investment of $100,000 and a 10% surrender charge and a surrender of $90,000.    

So why would anyone invest in this product?  Index annuities are complicated, often have lengthy surrender charges, actual historical returns are no better and often worse than other low-risk investments.  Two reasons.

  • Commissions and insurance company profits.
  • Misleading marketing.

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 years it lasts.  For example, a 10% surrender charge the first year which is declines to zero over ten years may indicate the gross commissions paid to the selling agency to be 10% of the investment or more.  The actual agent, depending on his/her production, would get a percentage of this.  In this example, a $100,000 would 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.  

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.  

Due to high commissions paid on many index annuity contracts, there is a substantial financial benefit to agents who sell index annuities and the misleading marketing makes it easy to do so.  Index annuities are often sold as a risk-free means of investing in the stock market, stock market upside with guarantees.  As outlined above, this is not true. It is a fixed annuity with a complicated method of calculating gain and actual historical returns or significantly less than hypothetical projections which are presented to the potential investor.  It sounds like a win-win, and it is for the agent and insurance company.  Not so much for the potential buyer.  

Certified Financial Planners® [CFPs®] like myself are subject to the Fiduciary Standard.  Registered representatives or brokers who are subject to the "Suitability Standard" which is a much lower standard, but insurance agents selling index annuities are not subject to either.  

I suggest that consumers need to be very aware and do due diligence before any investment decision.  I would also 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® 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 that do not pay commissions and are generally more cost-efficient to investors.  

*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.