Buyer Beware: The Siren Song of Fixed-Index Annuities
A fixed-index annuity (“FIA”) is a type of retirement investment product designed to offer the investor a chance to participate in a portion of annual stock market gains if stocks rise. If the market falls, you won’t lose your original investment even if there are steep market losses in a year. That’s an intriguing offer for someone that otherwise fears losing a hard-earned nest egg. But remember, there is no such thing as a free lunch.
Many retirement investors are attracted to fixed-index annuities, sometimes also referred to as equity-indexed annuities. On the surface, these retirement products sound almost too good to be true. You are likely to hear a “guaranteed not to lose” sales pitch. Be certain to dig a little deeper to understand the cost of this guarantee before you invest. There can be significant potential complications and additional expenses associated with these annuities.
How FIAs Work
You pay a lump sum to an insurance company that provides the annuity product. Your annual return is determined by a formula linked to a common stock market index, typically the S&P 500. As an example, you might earn 60% of the index’s annual gain up to a “cap” or maximum gain of 6%. Any earnings above the cap are forfeited to the insurance company. Conversely, if the index has a loss for the year, your investment earns zero, but your principal value remains unchanged.
The investor’s money is not actually invested in the stock market or an index itself which should be a red flag. Instead, it is held in what’s called a “separate account” by the insurance company. The company will credit any earnings into an annual interest payment that is then attributed to the separate account.
The Many Catches
Despite the “can’t lose” promise of FIAs, the hidden costs and restrictions of these investment products mean they often fall far short of investor’s expectations.
Those years when impressive stock market gains are made do not translate into impressive FIA investment gains because of rate caps. FIAs typically cap annual returns in a range of 4-6%. This provision can significantly limit an investor’s upside.
Fixed-index annuity products earn brokers and agents some of the highest sales commissions in the insurance industry which should be another red flag. These costs typically run up to 7% of the lump-sum amount paid to the insurance company. Furthermore, these costs are often not clearly explained to prospective investors.
Long Lock-up Periods
The lock-up, or surrender period, is the length of time the investor must keep the funds in the annuity to avoid penalties for any transfers or withdrawals. The lock-up period duration varies, but most FIAs average between 7 and 15 years. Typically, during a lock-up period you may draw no more than 10% of your account annually without penalty.
Dividends Not Paid
The formula used to calculate annual returns for FIAs does not take into account stock dividends. Only stock market price gains count. This creates another significant disadvantage for FIAs. From 1930-2017, dividends have contributed 40% of total S&P 500 returns.
Higher Tax Rates
If purchased with after-tax dollars, all withdrawals from fixed-index annuities are taxed at the investor’s ordinary income tax rate. For many investors, this tax rate is higher than investing directly in the stock market and paying taxes on capital gains and dividends.
Understanding all the catches, it’s no wonder FIAs long-term returns are being heavily discounted by savvy investors. Scott Witt, a Wisconsin-based annuity consultant to financial advisors and affluent investors, estimates investors can expect a 3.5%-to-5% annual return from FIAs. Deduct another 2%-to-2.5% to account for inflation and it’s clear you’re not getting paid much for the complexity and risk of these products.
Before you consider a fixed-index annuity, you need to be aware of the disadvantages as well as the advantages. Based on your investment objectives, there may be investments better suited to your needs. Talk to us. We’d enjoy having that conversation with you.
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