Understanding Indexed Annuities

Last week All Financial Matters posted about a seminar his father went to where the presenter offered indexed annuities as a safer investment alternative. That inspired him to compare a hypothetical indexed annuity to the S&P 500 from 1950 – 2006. The conversation it started is very interesting. Most interesting to me was to read different peoples perceptions of indexed annuities and see some of the misconceptions about how they work and when they can be useful.

First a disclaimer, I remain neutral in the whole debate. I have no emotional ties to any financial products. It is my belief that financial products are neither good nor bad, they are just tools. When a helpful tool is used improperly it may no longer be safe. If you need some background, you may want to read my post "What Is An Annuity?" before jumping into this.

What are Indexed Annuities?

Simply put, indexed annuities are fixed annuities where the interest credited is calculated based on market index performance. In the marketplace today there are a wide variety of formulas and indexes available. It would be counter-productive to try and define all the possible combinations. For illustrative purposes I will use the same assumption All Financial Matters used which is a 1 year point to point of the S&P 500 with 100% participation and a 10% cap. Huh? What does that mean? Let me translate that for you.

A point to point formula looks at a market index at the beginning an end of the year. In this case, we are using the S&P 500 but we could have used the Dow, Russell, or any other index. Let's say the S&P was 1000 at the beginning of the year and 1070 at the end of the year. That is a growth of 7%. Multiply the growth by the participation rate (in this case 100% so it is still 7%). Finally, if the growth is higher than the cap, reduce the rate to match the cap. That is, the interest credited can never exceed the cap rate in any given year regardless of the index performance. You also need to know that in an indexed annuity, you can never have a negative return. The lowest the return can be in any given year is 0%.

As annuities, indexed annuities are often subject to surrender charges. Surrender charges are a penalty like fee you have to pay if you terminate the contract in a specified number of years. Early indexed annuities often had long surrender charge periods (15 or more years) but guidance from the National Association of Insurance Commissioners has resulted in newer products with surrender charge periods of 10 years or less.

Are Indexed Annuities a safer investment alternative?

No. Indexed annuities should not be compared to or considered investments. The returns are much closer to a certificate of deposit than they are a mutual fund. In a CD the five year rate is hovering at about 5.5%. The 5 year average return for the S&P (period ending 8-31-2007) was 12.01%. I would hope that an indexed annuity would average returns somewhere in the 5% - 8% range, but there is no assurance that will actually happen. (All Financial Matters study from 1950 – 2006 showed the hypothetical indexed annuity would have averaged 6.81%)

If someone has the ability to stomach the ups and downs of the market, and a sufficient timeframe, I believe they are better off in the market. In 2002, when the markets were at a low point, I calculated the 10 year total returns on the last day of each month for the S&P and the DJIA. The S&P study started January 1950, and the Dow study started 1960. In all that time there was never a single ten year period where the indexes went negative. While this is no guarantee, history has shown that the risk of loss in the markets diminishes significantly if your timeframe is long enough. If someone is an investor, they should stay away from indexed annuities.

Are Indexed Annuities appropriate for anyone?

Yes. Some people have significant money in CD's. If the annuity surrender charges are not an issue, one may want to consider an indexed product. In exchange for FDIC insurance and an interest rate which is set in advance, you can gain tax deferral and potentially higher interest. Of course the interest could end up being lower too depending on how the index performs. Another appropriate use of indexed annuities would be when an investor no longer has a long enough time frame to be comfortable with the gyrations of the market.

Can you lose money in an indexed annuity?

Yes you can. If you exit an indexed annuity while the surrender charges are still more than the interest you have been credited, you will end up with less money than you started with. But once the interest earned exceeds the surrender costs, taking a loss is no longer an issue.

In summary, indexed annuities are complex tools. They are not investments, nor should they be considered alternatives to investments. While they can serve a useful function for a limited group of people, they are not for everyone. Seek trusted professional advice if you have any doubts.

Confusion! Photo by LuluP

Comments

[Moochie]

I read much of the thread about IAs on All Financial Matters. I note that most of that discussion took place in 2007.

Since the collapse of the market in September 2008 and ongoing, what are your views of an IA at this time for a person 62 who is (further) loss averse and needs all he has, and more to be able to live beyond age 75. What other vehicles might he consider if not IA. Some said Variable Annuities might have a higer upside potential and still minimize/prevent loss.

[Fixed Annuity Rate]

I was looking around for some posts and dropped in your blog. I found your post kinda interesting. I also checked out more blog posts on your site. Great work done!

[phoenix carpet cleaning]

If you are looking that far back absolutely the index annuity would trail. I think it plays off the fears of people but generally most people need to be in the market if investing on a long horizon.