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How Well Do You Know Indexed Annuities?

Money-Guy 06-24-2010

What if I told you there was an investment where you had a guaranteed rate of return when the stock market was doing poorly, but then you could make even more when the stock market goes up? Sound too good to be true? Well, it just may be…

I feel like today’s show is very timely because I have been receiving questions about these products from both listeners and clients. The products I am speaking of are equity-indexed annuities or indexed annuities or fixed-indexed annuities or even ratchet annuities. These are all really different names for the same thing.

The way these products are typically pitched is by saying you are guaranteed a minimum return (usually around 2% – 3%) while still maintaining the potential to earn gains in the stock market. On the surface it sounds like a win-win proposition. But what are they not telling you?

There are two very big considerations that most investors don’t recognize when they are considering using these insurance products. They are:

  1. There are usually surrender penalties of 10% to 15% that apply in the first year of the contract. These surrender charges usually decrease as time passes, but don’t disappear for 5 to 15 years. This is a big problem because it essentially locks up your money. While some products allow you to withdraw up to 10% a year penalty free, this is still a dangerous (and expensive) proposition if you have an emergency that requires access to this money.
  2. These annuities limit your upside potential. Some only give you a percentage of the stock market gains while others will impose a cap on your earnings (usually around 7% – 8%) despite how well the index it is attached to performs.

So let’s look at some VERY simple numbers. We are going to assume you purchase a $100,000 Equity Indexed Annuity pegged to the S&P 500 with a guaranteed return of 3% that caps at 7%. We won’t even consider any fees associated (usually there is a 6% – 10% immediate commission to the salesman who sells this product). Finally, lets look at the last 20 years so we won’t even take into account having to access the money before the surrender period ends. We will compare these numbers to how you would have done had you just invested directly in the S&P 500:



Growth of $100k

Annuity Return

Growth of $100k

1990 -3.2% $                   96,830 3.0% $                 103,000
1991 30.6% $                 126,412 7.0% $                 110,210
1992 7.7% $                 136,107 7.0% $                 117,925
1993 10.0% $                 149,704 7.0% $                 126,179
1994 1.3% $                 151,666 3.0% $                 129,965
1995 37.4% $                 208,434 7.0% $                 139,062
1996 23.1% $                 256,520 7.0% $                 148,797
1997 33.4% $                 342,095 7.0% $                 159,212
1998 28.6% $                 439,865 7.0% $                 170,357
1999 21.0% $                 532,413 7.0% $                 182,282
2000 -9.1% $                 483,910 3.0% $                 187,751
2001 -11.9% $                 426,422 3.0% $                 193,383
2002 -22.1% $                 332,183 3.0% $                 199,185
2003 28.7% $                 427,519 7.0% $                 213,128
2004 10.9% $                 473,990 7.0% $                 228,047
2005 4.9% $                 497,263 4.0%* $                 237,169
2006 15.8% $                 575,831 7.0% $                 253,770
2007 5.5% $                 607,444 5.0%* $                 266,459
2008 -37.0% $                 382,690 3.0% $                 274,453
2009 23.5% $               472,622 7.0% $               293,664

*Another confusing feature of these products is how each one calculates the indexes gain. Becuase of the varying calculation methods, it is very difficult to compare one annuity product to another.

Another thing you may want to think about is that this very simple illustration uses the S&P over the last decade which has been one of the poorest performing decades in history for this index. While looking at this (and again, this is a very simple illustration. We realize there are many other variable that aren’t shown), it is clear to see that you would have most likely been better off over the last 20 years to just buy the index as opposed to purchasing an indexed annuity.

As you listen to the show, we explain in depth some of the additional features as well as considerations you may want to make while looking at these particular products. We even walk through a quiz that was featured here at the Wall Street Journal online. Two other additional articles you may be interest in reading are Indexed Annuity: Buyer Beware and Ups and Downs of ‘Equity-Index’ Annuities.

We also share some of our thoughts from a macro-economic perspective and why things could potentially be looking up for the U.S. over the next 10 – 20 years.

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