Can you get principal protection and investment growth? That’s what index annuities promise. But despite their popularity, this complex investment product doesn’t always deliver. So, it is important to know exactly what you are buying before taking the plunge—and to consider the alternatives.
What is an indexed annuity?
An indexed annuity is a contract issued and guaranteed1 by an insurance company. You invest an amount of money (premium) in return for protection against down markets, the potential for some investment growth, which is linked to an index (e.g., the S&P 500® Index), and in some cases a guaranteed level of lifetime income through optional riders.
How is the return calculated?
One element of indexed annuities that is often misunderstood is the calculation of the investment return. To determine how the insurance company calculates the return, it is important to understand how the index is tracked, as well as how much of the return of the index is credited to you.
Know what you’re buying
Because indexed annuities are not considered securities, they are not regulated by the Securities and Exchange Commission (SEC) or by the Financial Industry Regulatory Authority (FINRA). However, they are regulated by state insurance departments.
The insurance company controls your upside. By imposing caps, participation rates, and spreads, it can reduce your return potential.
You pay an opportunity cost by sacrificing some of your return, and you may pay hefty surrender charges if you take your money out too soon.
Index tracking. The amount credited to your account depends, in part, on how much the index changes. Insurance companies use various methods to track changes in the index value. For example, they may use different time periods such as monthly, annually, or over even longer periods of time. It is important to understand how the index is tracked, as it will have a direct impact on the return credited to you.
Return credited to you. The amount an insurance company credits to you depends on a variety of factors (any of which can potentially be combined), such as:
- Cap is an upper limit put on the return over a certain time period. For example, if the index returned 10% but the annuity had a cap of 3%, you receive only a maximum 3% rate of return. Many indexed annuities put a cap on the return.
- Participation rate is the percentage of the index’s return the insurance company credits to the annuity, typically ranging from 80% to 100%. For example, if the market went up 8% and the annuity’s participation rate was 80%, a 6.4% return (80% of the gain) would be credited. Most indexed annuities that have a participation rate also have a cap, which in this example would limit the credited return to 3% instead of 6.4%.
- Spread/margin/asset fee is a percentage fee that may be subtracted from the gain in the index linked to the annuity. For example, if an index gained 12% and the spread fee was 4%, then the gain credited to the annuity would be 8%.
- Bonus is a percentage of the first-year premiums received that is added to the contract value. Typically, the bonus amount plus any earnings on the bonus is subject to a vesting schedule that may be longer than the surrender charge period schedule. Given the typical vesting schedule, the bonus may be entirely forfeited upon surrender in the first few contract years.
- Riders are extra features that can be added to the annuity for additional costs, further reducing the return.
“One challenge here is that insurance companies typically have the flexibility to lower the participation rate, increase the spread, or lower the cap, which lowers your potential returns,” says Tom Ewanich, a vice president and actuary at Fidelity Investments Life Insurance Company. “If this happens during the surrender charge period after you’ve invested in the annuity, you have very little recourse.”
In addition, an often overlooked point is that indexes exclude dividends, so your return from an indexed annuity will also exclude dividend income. This is important because history indicates that dividends have been a strong component of equity returns over the course of time. Since 1930, dividends have made up approximately 40% of the S&P 500's average annual total return.2
How does a cap impact potential returns?
The chart below uses a representative indexed annuity with a monthly cap on upside returns. In 2013, while the S&P 500 Index returned 29.60% (32.39% including dividends), this indexed annuity was credited only 9.98%.
Now look at the cumulative effect of this crediting methodology over the 10 years ending Dec. 31, 2013. The S&P 500 average annual return was 7.41% (5.21% without dividends), while the indexed annuity returned only 3.23% annually—despite an 8% initial bonus and guaranteed annual floor of 0%. The return on indexed annuities is typically comparable to a conservative investment product's return, and not to the stock market, a stock market index, or stock fund returns.
To better understand this, let’s take a look at another example, this time comparing an indexed annuity with a conservative investment strategy - a portfolio that has 90% invested in 10-year zero-coupon Treasuries3 and the other 10% invested in the S&P 500 index.
In our example, both start with $100,000 invested. The assumptions for the indexed annuity include:
- In a given policy year, if the S&P 500 loses value, the policy will be credited 0%.
- If the S&P 500 returns more than 2.75%, the policy will be credited 2.75%.
- If the S&P 500 returns from 0% to 2.75% the policy will be credited the S&P 500 return.
- At the end of a 10-year period, the annuity account value will be 108% of the premium (based on an 8% bonus) plus 10 years of return credited to the investor, assuming no withdrawals.
Both the annuity and the conservative investment strategy are guaranteed to return at least $108,000 at the end of the 10-year period - the annuity thanks to the 8% bonus and the conservative investment strategy thanks to the growth of the zero-coupon Treasury given the interest rate and starting balance.
90% in Zero-Coupon Treasuries
10% in S&P 500 Index
|Average Ending Balance after 10 years4||$129,864||$139,502|
Both the indexed annuity and the conservative investment strategy have been simulated over 53 10-year periods, and as you can see, the average ending balance of the conservative investment portfolio is about $10,000 higher.
“Investors often mistakenly think they are investing in the market directly with an indexed annuity and are surprised when their actual return does not measure up,” says Tim Gannon, a vice president of product management at Fidelity Investments Life Insurance Company.
Another way to look at this is to see how this representative Indexed Annuity would have performed in the past compared to the index that it would have tracked. The chart below shows rolling 10 year periods going all the way back to 1926, with each point on the lines representing an annualized return for the 10 year period beginning in that month. Note that the S&P 500 Index returns are significantly higher in the majority of periods, while the Indexed Annuity stays within a narrow range.
How much do they cost?
Indexed annuities typically do not have an up-front sales charge, but there are often significant surrender fees—fees you pay if you need access to your money before the surrender period ends—and other hidden costs. “While index annuities are often sold as ‘no-fee’ products, investors still incur a cost to own these products,” explains Gannon. In fact, surrender fees for the 10 top-selling indexed annuities averaged 11% in the first year.5
“In addition, indexed annuities have significant opportunity costs that are passed on to customers by the insurance company by limiting potential returns through a participation rate, cap, or spread,” notes Gannon. "That’s why, it is important to ask your agent to explicitly define how the product works so you will know up front about any factors that could put a drag on your potential return.”
Can you lose money?
The answer, in some cases, is “yes.” If the market index linked to your annuity goes down and you receive no or minimal index-linked return, you could lose money on your initial investment if you withdraw assets before the surrender period is up.
“Your principal is protected only if you hold the annuity through the surrender period, which could be 10 years or longer,” says Ewanich. “Unfortunately, many investors believe that, regardless of what happens in the market, they get all their money back with these products. But this is not always true.”
So what is the minimum amount you might get back? Index annuities may guarantee a minimum of only 1% to 3% interest each year on 87.5% of the premiums you invest6, as defined in state insurance laws. So, if you invested $100,000, you might be guaranteed from 1% to 3% a year on $87,500.
What’s more, in an effort to attract more customers, these products are offering certain riders for an additional cost. For example, many companies offer a guaranteed living withdrawal benefit at an average cost of nearly 1% that promises a guaranteed withdrawal amount7 for life with upside potential. Because of the indexed annuities’ participation rates, spreads, and caps, however, upside potential is generally limited. Be sure to determine whether the benefits outweigh the extra cost.
Does it fit your needs?
“Indexed annuities can be a challenge to understand, so be sure to do your homework,” advises Gannon. Depending on what you are looking to address, it may be in your best interest to consider a different type of annuity or combination of investment products.
For example, for lifetime income and market participation, investing in a deferred variable annuity with a guaranteed lifetime withdrawal benefit may make more sense. On the other hand, for principal protection and market participation, you may benefit from a strategy that invests a portion of your assets in a conservative investment, such as bonds, and the remaining portion of your assets in the stock market, for upside potential.
“A financial representative can help you build a comprehensive plan that takes into account your specific needs and objectives,” says Gannon.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917