Fixed-indexed annuities offer the best of both worlds–guaranteed returns and upside potential–or so goes the sales pitch. When financial advisors and insurance agents use this pitch, they’re not giving the full story. So what are they leaving out? The best way to answer this question is with an example. But first, a few observations are in order.
- The basic bargain with all deferred annuities is that the owner pays a premium or premiums and the issuer agrees to make a stream of future payments to the designated annuitant (usually the owner). The stream of future payments does not begin until the owner elects to “annuitize” the contract, which is often not allowed during the first 5 to 10 years of the contract. The payment stream typically continues for the life of the annuitant or for a period certain, depending on the terms of the contract.
- Prior to annuitization, the owner’s premium payment(s) are held in a contract account, where they either grow by a fixed or fixed-minimum percentage (fixed and fixed-indexed annuities), or where they are invested directly in the securities markets (variable annuities). Fixed-indexed annuities typically guaranty a fixed minimum return of 1 to 2%, or that there will be no loss in the contract account. They also provide for potential returns in excess of the guaranteed minimums. The potential excess returns are calculated by reference to an index identified in the annuity contract (e.g., the S&P 500).
- Fixed indexed annuities are long-term investments. In the short and medium term, investors can only access the funds in their contract account by paying a surrender charge, which could be as much as 20% of the account value. The charge period varies annuity to annuity, but it is typically 7 to 10 years. The charge usually declines (in percentage terms) over the course of the charge period.
- Most annuities are sold with an optional living benefit rider, for which the investor must pay an annual fee, usually 1 or 2% of the contract value. The living benefit is usually in the form of monthly payments that continue for the annuitant’s life, or for a proscribed number of years. The amount of the payment is typically calculated as a percentage of a notional account, sometimes referred to as an income account. The balance of the income account is equal to premiums, plus guaranteed “step-ups,” less any excess withdrawals. Most annuities guaranty “step-ups” for a specified number of years (e.g., guaranteed 7% increase in the notional account for five years).
- Most annuities provide for a death benefit, which is usually nothing more than an agreement that, in the event of the annuitant’s death, the issuer will pay the contract account value to a designated beneficiary. Don’t be fooled into thinking this is life insurance; it isn’t. Note also, that this benefit is only available prior to annuitization.
- Issuers of fixed-index annuities pay substantial commissions to their sales agents (often 5 to 8% of the initial premium), which are typically paid up-front . So, before the ink is even dry on the annuity contract, the investor is down 5% to 8%.
There is much, much more to say about annuities, and fixed-indexed annuities in particular, but the information above will suffice as background for our example.
Our hypothetical investor is 62-years old, has a $700,000 net worth, and has a $500,000 liquid net worth. She has followed her financial advisor’s recommendation to purchase a fixed indexed annuity and living benefit rider, for which she will pay an annual rider fee of 1.5%. Assume that our investor is still working and intends to continue working to 67. Accordingly, she does not anticipate needing to make withdrawals during the annuity’s surrender period, which we will assume is 7 years. The additional key features of the annuity are as follows:
- The issuer guarantees against any loss in the contract account.
- The issuer agrees to pay “index income” calculated by reference to a 50/50 blended index of stocks and bonds.
- The equity component of the blended index does not include dividends (this is typical).
- The contract contains a 2% “spread” clause, i.e., a clause stating that the index income will be 2% less than the index returns (this type of clause is not uncommon).
- If our investor elects to annuitize, she will receive monthly payments equal to 0.41% of her contract account balance at the time she annuitizes (equal to 5% per annum).
- The living benefit rider provides for 7% annual “step-ups” of the notional income account for a period of 7 years, provided no withdrawals are taken during that time period.
Assume our investor reaches the end of the 7-year surrender period without taking any withdrawals, and further assume that she received “index income” in the range of 0% to 3% per year during that time. This is a fair assumption because:
- The historical mean return for a 50/50 blended portfolio of stocks and bonds (on a total return basis, i.e. including dividends) is approximately 7% to 8%.
- The historical mean has to be adjusted downwards in our investor’s case to account for dividends.
- The index returns have to be reduced by 2% in accordance with the spread clause.
- The returns should be reduced by a further 1.5% to account for the rider fees.
Based on the foregoing, we can safely assume that, in the vast majority of market cycles, our investor will end up in a far worse position at the end of 7 years than she would if she had simply put her money in a suitable index mutual fund. You might think this is a fair trade off, given that our investor is guaranteed not to lose money, but the lack of upside participation is likely to more than offset any negative return years. At this point, if the investor decides to annuitize, she is giving up any potential for future gains. She would no longer have an account to grow. All she would have is the promise of future monthly payments. So, if our investor lives to 87, which is the approximate actuarial life expectancy for women in Michigan, she would be missing out on 20 years of potential capital gains and income. This translates to hundreds of thousands of dollars. No wonder the insurance companies love indexed annuities so much! If our investor decides not to annuitize, and to instead take withdrawals under the living benefit rider, she faces the same issue. Indeed, once the guaranteed step-ups end, her income account will not go up in notional value. And, although the contract account will continue to be eligible for index income, it will be reduced dollar for dollar by each withdrawal taken under the living benefit rider. So what is our investor to do? There don’t appear to be any good options. She could request a full surrender, and that might work prospectively, but it would not address the damage that has already occurred.
If you have purchased an indexed-annuity product, or any annuity product for that matter, and are concerned that the investment was unsuitable, contact Dan Broxup at Mika Meyers PLC for a free consultation and case evaluation.