In the aftermath of the stock market crashes of 2000-02 and 2008-09, an insurance product called an indexed annuity has been heavily promoted on talk radio and at “educational” dinners.
Unlike fixed annuities, which grow at a low, constant rate, or variable annuities, which rise or fall with their underlying investments, indexed annuities promise something special: When a stock index—often the S&P 500—goes up in value, your account is credited with some of the upside, but when it goes down your account does not decline.
That’s right: You get to participate in the growth of the S&P, without any downside risk.
But, as the saying goes, nothing ventured, nothing gained. There’s simply no way to earn what the market does without putting your dollars at risk. So, how do indexed annuities work?
It’s important to recognize a couple things about this product. First, the insurance companies offering indexed annuities don’t invest your dollars directly in the advertised index. By their nature, insurers are prudent and risk-averse investors, whose conservative portfolios concentrate on high-quality bonds. Second, the agent selling the annuity receives a commission, in some cases 10% of the contract.
Now, insurance companies don’t like to lose money. This means that indexed annuities can’t sustainably give contract-holders returns greater than those earned in the insurer’s conservative portfolio, less any commissions paid to agents. To make a profit, insurers must significantly limit how much an investor gets to participate when stocks go up.
This is where things get fun. When computing how much growth should be credited to an investor’s account based on the return of an index, insurance companies employ a variety of tricks, using language and math that is difficult for the lay person to understand.
Let’s look at an example.
2-Year Monthly Cap Indexed Account
Index (excluding dividend income): S&P 500
Initial Monthly Indexed Cap: 2.35%
Guaranteed Minimum Monthly Indexed Cap: 1.00%
Initial Indexed Term: 2 Years
Subsequent Indexed Term: 2 Years
The monthly change percentage equals the lesser of the change in the index or the monthly indexed cap.
The index credit percentage for an indexed term equals the sum of the twenty-four (24) consecutive monthly change percentages during the indexed term. The index credit percentage will never be less than 0.00%.
Has your head exploded yet? Indexed annuity contracts are mind-numbingly complex. But let’s work through the language to see what it means for a contract-holder’s returns. To make things concrete, we’ll focus on the 12 years between 2003 and 2014, when the annualized total return of the S&P was 9.55%
For this contract, the account is credited every two years an amount derived from the monthly changes in the S&P 500’s price during that term. This “index credit percentage”—what the investor gets—is reduced in several ways, some obvious, some less so:
♦ No Dividends. Between 2003 and 2014, dividends accounted for about 23% of the S&P’s total return; an indexed annuity owner would have seen none of this.
♦ Low initial monthly cap. Capping the monthly return at 2.35% may not seem bad—you’d earn 56% if the S&P magically returned 2.35% for 24 consecutive months—but market returns are lumpy, and most of the S&P’s long-term gains come from months with even higher returns. Between 2003 and 2014, there were 93 months with a positive change in the S&P, and half of these were greater than 2.35%.
♦ Even lower guaranteed monthly cap. What’s more, the insurance company is free to shrink the monthly cap to 1% after the initial two-year term—and why wouldn’t they? Between 2003 and 2014, this would have capped the gain for four out of every five positive months.
♦ No monthly cap on the downside. Yes, at the end of each two-year term, the account will not decline in value, regardless of how badly the S&P slumps. This is a key selling point of indexed annuities. But when the S&P grows during a two-year term, the index credit percentage—again, what the investor gets—is weighed down by all the negative months, which are never capped. By capping positive months but not negative months, even good periods for the S&P (e.g., 2009-10 and 2011-12) can result in 0% being credited to the annuity.
♦ No compounding. Within any two-year term, the monthly returns (after capping the upside) get added up, rather than compounded like they do in real life. This can significantly reduce the return that gets credited.
For the period between 2003 and 2014, an indexed annuity with the above characteristics, whose monthly cap decreased to 1% after the initial term, would have returned a paltry 1.79% annualized. That, ladies and gentlemen, is how you derive low returns from a booming S&P 500.
Besides low returns, there are other disadvantages to indexed annuities, the most prominent being that they are subject to “surrender fees” if you try to withdraw your money before a certain amount of time has elapsed. That’s why the example above considered a 12-year period—it could take that long to recover all of your principal and earnings without forfeiting anything. But if you’re willing to accept a decade or more of low returns and illiquidity, why not just buy 10-year Treasury bonds and hold them until maturity?
Once you strip away the fancy language and math, the lesson is clear: If you seek higher returns—akin to what the S&P 500 has, historically, provided—you need to be comfortable with a commensurate level of risk. And, if you seek a low-risk savings alternative, there are plenty of simpler and cheaper options.
 Our return calculations are based on historical data from one time period and should not be used to predict future performance. There are circumstances in which an indexed annuity can outperform its index.
 To add insult to injury, an indexed annuity’s gains are eventually taxed as ordinary income, whereas dividends and realized gains from an S&P 500 index fund held for more than one year are qualified and thus taxed at a lower rate for most people.
By Jeffrey P. Ebert, PhD, CFP® / Financial Advisor
Jeff holds the CFP® designation and earned his doctorate in social psychology at Harvard University. Jeff has expertise in retirement and education planning.
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