Robert A. Sparrow
Financial Wellness co-columnist Robert A. Sparrow is a partner with Triune Financial Partners LLC. He helps his clients learn how to live within their means, save, avoid debt, give generously, and set goals – the five fundamentals to leading a financially stable life. He specializes in resolving complex financial situations, and serves clients facing big life changes, such as the sale of a business or the transition into retirement. Learn more at triunefp.comRead Articles Written by Robert A. Sparrow
Financial Wellness co-columnist Fritz Wood is a veterinary industry veteran with a special interest in finance. He works with Triune Financial Partners to connect veterinarians with experienced, independent financial planners. He is the former personal finance editor of Veterinary Economics and was a treasurer and board member at the American Veterinary Medical Foundation. He holds bachelor degrees in accounting and business administration from the University of Kansas.
Many sellers of indexed annuities use the same approach with clients: the allure of stock market returns without the possibility of a loss in value. On the surface, the pitch is appealing, but is it too good to be true? Think about the message. Market returns without the risk of loss. What’s the catch?
Defining the Terms
Indexed annuities also are known as fixed-index annuities, equity-indexed annuities and registered index-linked annuities. All are insurance contracts that credit a modest, guaranteed interest rate over a fixed number of years. Indexed annuities differ sharply from index mutual funds and are heavily marketed, especially to the 55- to 65-year-old bracket.
An indexed annuity account may receive an interest credit based on the percentage of change in the value of a broad market index, typically the Standard and Poor’s 500. The additional interest, if any, is calculated using a formula that determines how much of the change in the index is captured by the policyholder. Insurers typically use cap rates and participation rates to limit the amount of credited interest.
A cap rate is the most you could be credited, depending on the index and selected time frame. So, a cap rate of 7% doesn’t sound bad, especially since you have protection from loss, but the participation rate can erode the credit.
The participation rate is the amount of return one can participate in. For example, a rate of 50% limits the index return by half. So, suppose an indexed annuity has a cap rate of 7% and a participation rate of 50% of the change in the value of the S&P 500, and the index returns 10% in a policy year. The participation rate applies in that case, and 5% is credited to the account.
Worse, dividends are usually excluded from the index’s total return for purposes of the formula. For example, if the S&P 500 returned 10% but 2% of those returns are from dividends, many annuities would consider 8% to be the index’s return when calculating additional interest for your indexed annuity. In this instance, the credited amount would be 4%, given a 50% participation rate.
Remember that annuities are insurance products, not securities. The U.S. Securities and Exchange Commission does not regulate annuities.
Reasons to Be Wary
We dislike indexed annuities and seldom see how they fit into a well-designed financial life plan. Let’s count the ways.
1. Actuaries design insurance products to provide hefty commissions to the salesperson and handsome profits to the insurance company.
2. You don’t own securities but rather an insurance company’s promise to pay. The SEC’s Investor Bulletin states, “Remember that all amounts payable are subject to the ability of the insurance company to pay. If the insurance company experiences financial distress, it may not be able to fully meet its obligations to you.” (You regularly follow the insurance company’s Comdex rating, right?)
Compared to buyers of index mutual funds, “Buyers of indexed annuities concede several benefits that are routinely enjoyed by fund shareholders,” says Morningstar’s John Rekenthaler. “Besides the ability to conduct meaningful investment research, they forgo liquidity, transparency and custodial protection. Indexed annuities divulge neither their investment tactics nor their expense ratios, and their scheduled payments consist solely of promises.”
In stark contrast, mutual and exchange-traded funds possess assets held in custody by a third party. If a mutual fund company goes bankrupt, the fund is unaffected. Shareholders still own the same fractional interest in those underlying assets held in custody.
3. Watch for surrender charges. If you exit the contract early, you’ll pay one. Whenever possible, avoid financial decisions that limit your future flexibility and tie your hands. Also, many annuity contracts allow the insurance company to change how gains are credited. That’s often undisclosed.
4. You’ll never enjoy market returns because indexed annuities aren’t designed to do that.
5. The salesperson is not a fiduciary, your interests are not primary, and sales commissions on many indexed annuities can be excessive. Given human nature, do you think insurance agents push low-commission products? Are they inclined to act in your best interest to the detriment of their commissions?
6. Transparency and comparability are lacking. According to Rekenthaler, “Most indexed annuities are unaccompanied by a prospectus. Ultimately, the investment must be made on faith.”
7. Beware the opportunity cost. Money invested in an indexed annuity is tied up for years. Exceptions are limited.
8. Beware of taxable withdrawals. Sellers tout annuities as a great way to defer income taxes as the account grows. While that is true, what is typically undisclosed is the disadvantageous treatment that annuities get when you make a withdrawal. For example:
- Annuity gains are taxed at ordinary income tax rates, which can significantly exceed more favorable capital gains rates for most people.
- IRS rules require that any withdrawals from an annuity must come first from accumulated gains, which therefore are taxed. Not until you withdraw all the gain may you take further distributions tax-free.
- You never avoid income tax on the accumulated annuity gains, even in death. Your heirs will pay their proportionate income tax on any gain passed to them. Contrast this with the tax treatment of investments outside of an annuity. The law allows your heirs to receive a “step-up in basis” that raises the cost basis of your investments to the fair market value at your date of death. The heirs may sell those investments later and only be taxed (at more favorable capital gains rates) on the gain in value from the date of death, not the original purchase price.
So, how do you avoid investment losses? You can’t, but a well-designed financial plan will provide for an investment allocation based on your needs and can help mitigate portfolio volatility. We suggest:
- Holding short-term capital needs in cash (checking, savings, money markets).
- Holding midterm capital needs (years 3 and 4) in short-term, investment-grade bonds.
- Investing long-term needs (years 5-plus) in a globally diversified stock portfolio.
- Revisiting your changing needs and reallocating your portfolio allocation once a year to allow for wise decision making through all market cycles.
When something seems too good to be true, seek a second opinion from someone who prioritizes your interests, such as a certified financial planner acting as a fiduciary.
According to Retirement Income Journal, independent insurance agents can earn higher commission payouts from selling indexed annuities than any other insurance product. The sale of an annuity funded with $200,000 can generate $13,000 for the agent, assuming a 6.5% one-time commission.