- An annuity is only as good as the insurance company's ability to honor its commitment to you, so be sure to review the financial strength of the insurance company.
- Indexed annuities are not considered securities, so they are not regulated by the SEC or FINRA. However, they are regulated by state insurance departments.
- By imposing caps, participation rates, and spreads, the insurance company can reduce your upside in exchange for guarantees.1
Can you get principal protection and potential investment growth? That's what indexed 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 negative returns in the US equity market; the potential for some investment growth through being 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 potential investment return calculated?
One element of indexed annuities that is often misunderstood is the calculation of the investment return credited to your account. 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 index return is credited to you.
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 a month, a year, or 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.
The amount an insurance company credits to you depends on a variety of factors (any of which can potentially be combined), such as:
- Cap, which 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%, your account receives a maximum return of 3%. Many indexed annuities put a cap on the return.
- Participation rate, which is the percentage of the index’s return the insurance company credits to the annuity. 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, which 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, which 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 are subject to a vesting schedule that may be longer than the surrender charge period schedule.2, 3 Given the typical vesting schedule, the bonus may be entirely forfeited upon surrender in the first few contract years.
- Riders, which are extra features, such as minimum lifetime guaranteed income, that can be added to the annuity for additional costs, further reducing the return credited to the account.
"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 for the purposes of the insurance company calculation, an index return excludes 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. For example, over the past 20 years, ending October 2020, the S&P 500 index has gained 4.26% annually without dividends and 6.30% with dividends. Insurance companies are leaving 47% of the return on the table, and that’s before considering any caps, participation rates, and spreads.
This is not just a recent effect. Since 1930, dividends have made up approximately 40% of the S&P 500's average annual total return.4
How does a cap impact potential returns?
Let's consider the following chart, which uses a hypothetical indexed annuity with a monthly cap of 1.50% on upside returns.
Over the 10 years ending October 2020, the S&P 500 average annual return was 13.01% (10.70% without dividends), while the indexed annuity returned only 3.49% annually—despite an 8% initial bonus and guaranteed annual floor of 0%.
Taking a deeper dive, over the 10-year period ending October, 2020, the representative indexed annuity returned only a small portion of the positive US equity market returns.
As can be seen from this example, with indexed annuities you are giving up equity market return potential in exchange for downside market protection.
"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.
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.
"Also, 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."
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 a combination of investment products.
For example, 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.
For more information on strategies for protecting savings, read this Viewpoints article "Protecting yourself from fear of loss."
"A financial representative can help you build a comprehensive plan that takes into account your specific needs and objectives," says Gannon.