Should I Buy an Index Annuity?
Doug recently asked, “Should I buy an index annuity?” I get asked this often enough that I thought it was time to address it thoroughly and directly. Should you buy an index annuity? No.
Like all insurance products, index annuities were invented to capitalize on fear. Middling financial products are always lousy compared to the best financial plans. Since you’re not listening to this to be mediocre with your money, I assume you’d rather get superior strategies than buy inferior inventions.
First, we’ll examine why Financial Service Reps (salespeople calling themselves “financial advisors”) push these products so much. Then, we’ll discuss the cons that these reps blow over or ignore, which are more than the benefits.
Everyone who has an index annuity or who has an “advisor” trying to sell them the product should listen to this episode first.
What is an Index Annuity?
An index Annuity is an insurance product that “tracks” a market index, like the S&P 500. You initially contribute a lump sum of money to the product in exchange for some benefits and protections. These products are very popular because of their pros and hidden cons. There are many variations, bells, and whistles, but we’ll keep this general. If you have specific questions about a specific product, email us at Questions@RetireMentorship.com.
Why Financial “Advisors” Sell Index Annuities
There are four main reasons financial reps sell so many of these products.
- Downside Protection
- Upside Potential
- “Free”
- Commissions
Let’s look at each one.
The Downside Protection of an Index Annuity
So you want to invest in the “stock market,” but you’re afraid of the “risk,”—afraid of “losing money.” Perhaps you’ve retired or are close to retiring, and you “don’t have enough time for your money to come back.” But you know you need to get a better return than CDs and savings accounts, so you meet with a “Financial Advisor.”
The Financial Rep explains it this way. “What if you could invest in the S&P 500… with no risk? We don’t want you to lose 20, 30, or even 50% of your hard-earned money. I recommend we look at an Index Annuity. They track a market index but eliminate the risk. When the market is up, you make money. But when the market is negative, your money stays even. You will never lose money in this product.”
This sounds amazing! How does that work?
Two Types of Downside Protection
The products vary a lot, but this downside protection generally will look like:
- A Floor. The product will give some worst-case return if the market is down, usually 0%. If the market is up 5%, you get 5%. If the market is negative, you get 0%.
- Absorb the Loses. The product will absorb the first X% of losses. In a 20% example, if the market returns -15%, you’ll get 0%, and if the market returns -25%, you’ll get -5%.
This sounds pretty good. What’s the catch?
The Upside Potential of an Index Annuity
There are other products that don’t lose money. Savings accounts. CDs. US Treasuries. So why buy this product? Index annuities have some of the upside potential of the market.
The Financial Rep explains it this way. “Because they track an index, when the market goes up, you make money. The market is up more often than it’s down. In addition to preventing or reducing losses in the few years the market is down, you make much better returns when the market is high than you would in a CD.
“Now, if they are taking the losses for us, they are also going to cap some of our gains. But that’s okay. The important thing is to win by not losing. We’ll get a big chunk of the gains in the stock market and none of the losses.”
Index annuities have a floor, but they also have a cap. They will take any gains you have over the cap, which may be 5-10%. They will contend that the floor and cap average out to maintaining great returns without the risk.
The Cost of an Index Annuity: Free
Perhaps the best part of most index annuities is that they are “free.” There is no initial fee or ongoing fee to have your money in a standard index annuity. Free, free, free, free, free!
This is very appealing to cost-conscious investors and an easy selling point for financial reps. They can then average their total fee across a large free product and claim lower total fees to clients. They love selling the “free” nature of these products.
The Compensation of an Index Annuity: 3-10%
This last selling point for financial reps is not one they bring up to clients. Like all insurance and annuity products, index annuities pay the rep a commission. They may be as low as 3% on some fixed-indexed annuities and may be as high as 10% on others. 6-7% is standard. The rep doesn’t need to provide additional value or support. Once the sale is made, the check is cashed. Why wait 6-7 years to make that money on advisor-managed assets when you can make it now?
A Recipe for High Sales
These four elements, downside protection, upside potential, free cost, and high compensation, make these products very popular. There are a lot of free chicken dinner presentations about them. Which makes sense. If you sell one client a $100,000 policy and make $7,000, you can spend a lot on free chicken and still have plenty for your Maserati payment.
Index Annuity vs. Fixed Index Annuity
Now that you know more about these products, let’s break them down into their two major sub-categories
Regular Index Annuities
These will typically have higher caps and lower ceilings or loss absorption. They try to mimic the actual index in their “long-term returns.” (I put that in quotes because no one ever holds these for the long term. Reps will sell them, wait until they are out of surrender, and then sell the client a new shiny product.) If the S&P 500 is averaging 10%, they are trying to average that as well.
Fixed Index Annuities
These products will have a 0% or 1% floor and a 3-5% cap. To call it an index annuities is really a disservice to the index. A fixed index annuity tied to the S&P 500 won’t come anywhere near S&P 500 returns. Rather, when the S&P 500 is up, they will be on the high side of the range, and when it’s down, they will pay nothing.
Here’s what they don’t tell you about index annuities that make them bad investments.
Why You Should NEVER Buy an Index Annuity
There are three reasons to buy one. Here are seven reasons not to.
- They Lock Up your money.
- They have hidden costs.
- Companies change the parameters after you buy.
- They average less than the index they track by design.
- Caps and Floors are skewed down below average.
- You miss out on dividends.
- What they protect against is unlikely.
Let’s look closer:
All Annuities Have Surrender Periods
All commissioned annuities, including index annuities, have surrender periods and surrender charges if you try to get your money back out. These range from six to fifteen years, with most of them being seven years. If your product has a seven-year surrender period on it, and you take it out within that period, you are going to pay a penalty.
Index Annuities Have Hidden Costs
“Index Annuities are free!” Only if you follow the rules. If you want your money back, you’ll pay a big surrender penalty. These usually decline over time, with the successive penalty you pay each year looking like this:
- Year 1: 7%
- Year 2 7%
- Year 3: 7%
- Year 4: 6%
- Year 5: 5%
- Year 6: 4%
- Year 7: 3%
- Year 8+: 0%
Does that 7% look familiar? Yes, it’s the commission that they paid the financial rep. If they pay him 7% of your money, and then you take your money back, they are going to keep what they already paid.
You have no idea what is going to happen over the next seven years. Locking up your money is not a good idea.
Free Withdrawal Amount
Most annuities will let you pull 10% out per year penalty-free. Some people have asked me if this makes a fixed index annuity a good blue bucket in my strategy. The answer is no because you need to be able to pull 20-35% out of your fixed income per year.
Either way, paying 7% to get your money out is not free. It’s like saying, “Hey, there is no cost to getting into this movie theatre. But if you want to get out, it will be $50.”
Insurance Companies Can Change the Rules
Insurance companies love marketing their teaser rates. They will often guarantee some really good rates in the first year or two. But then they can change them in years two or three and beyond. Here are a couple of ways they mess with you after the fact.
Change the Cap and the Floor.
A fixed index annuity may boast about a 6% cap with a 1% floor. 6%? I can’t get six percent anywhere else. Sign me up! Then, in year two, they change it to a 4% cap and 0% floor. Wait, how many years am I stuck with the lower rates? Six more years!?
Change the “Participation Rate”
The participation rate of an index annuity is how much of the changes in the index you get. A 100% participation rate means you get 100% of what the index does between the lines. A 50% rate means you’ll make half the movement. Here’s where they can mess with you.
Example A
Let’s say you buy one now when the S&P 500 is near an all-time high. They market it with 100% participation with a 10% cap and a 0% floor. You’re tired of all the volatility of 2020-2023, and you want something more stable. You sign up.
The market then drops 10% during the first year, and you lose nothing. You’re thinking this is pretty good. Then the market is up 15%, and you’re thinking, “Well, I should have made at least 10%.” Nope! 7.5%. Why? Because they changed the participation rate to 50%.
Here’s the difference between what the index and your money can do over seven years with shifting participation rates on $100,000
Index +/- | Participation Rate | Your Rate | Your Money | Index Money |
---|---|---|---|---|
-10% | 100% | 0.0% | $100,000 | $90,000 |
+15% | 50% | 7.5% | $107,500 | $103,500 |
-5% | 50% | 0.0% | $107,500 | $98,325 |
+30% | 25% | 7.5% | $115,563 | $127,823 |
+18% | 33% | 8.9% | $125,859 | $162,335 |
-20% | 100% | 0.0% | $125,859 | $129,868 |
+37% | 80% | 10.0% | $138,445 | $177,919 |
Three times you hit the floor. Three times the market was over the cap, but you didn’t hit the cap because of the participation rate. And only once did you hit the cap. Money invested straight into the index would have averaged 8.6%, while you only averaged 5.6%. Still think these index annuities follow the index? That thought would have cost you $40,000 in this example.
Index Annuities Often Track “Specialty” Indexes
Some product track the S&P 500. Others track the “S&P 500 Point-to-Point.” Sounds the same, right? It’s not.
The short explanation is that they design special versions of the famous indexes that are designed to reduce the amount they need to pay you. I saw a history of a fixed index annuity once that followed one of these special S&P 500 accounts. It has a 5% cap an 0% floor. In the previous five years, the S&P 500 was up more than 5% four times and was negative once. They should have received 5% four times and 0% once, for an average of 4%, right? Nope. They’re average as 1.5%. How? Special S&P 500.
Index Annuity Caps and Floors are Below Average
The S&P 500 averages 10% annually over long periods of time. Thus, an annuity that offers a 0% floor and a 10% cap feels like you’ll get close to the average. But upon closer look, you’ll see that’s not possible.
We know sometimes the market is down and has a negative return. A floor to stop that sounds good. We hate “losing” money. But if it averages 10%, then we know that for each time it is negative, it must be more than 10% higher than 10% to make up for it. If it is -10% in a year, to average out to +10%, you would need a +30% year. So if your floor is going to clip off 10% of losses (from -10% to 0), then you also know it’s going to clip 20% of gains (from 30% to 10%). Index Annuities cap your gains far more often than they stop your losses by design.
Think about that. In Example A above, even if you had 100% participation rates the whole time, you’d still be capped 4 out of seven times. Your average return would improve, but only to 5.6% instead of 8.6%. You’d be up to $146,000, still $30,000 short of the index.
Index Annuities Don’t Pay Dividends
One of the best reasons to be co-owners of the best businesses in the world is that you get the profits. Being a true owner—investing in a fund of the actual companies in the index—means that you get the dividends that are paid quarterly.
But when you buy an index annuity, you are not buying the companies. You are buying and insurance product that tracks the companies. This means you do not get dividends.
Dividends generally make up 1-2% of the annual return of the S&P 500. If you slap a 1.5% dividend on Example A above, the Index would average not 8.6%, but 10.1% with dividends reinvested. You’d be up to $195,000 on your initial $100,000.
Even if you had an index that had no caps, and just tracked the S&P 500 for free, you’d still lose money.
Some Index Annuities Protect Against the Very-Unlikely
There are some annuities that sound great, but are mostly useless. For example there is one with a six-year point-to-point 100% Cap and a 25% loss absorption. What this means is that they will check the index when you start and at the six-year mark. If the market is down at year six, they will absorb the first 25% of losses. (Down 10%, you break even. Down 30%, you’re down 5%.) If the market is up, they will not cap it unless you have more than doubled your money (100% growth). (If your money went up 80%, you make 80%. And if it is up 120%, you are up 100%.)
They really sell this well. They say, “Do you think your money is going to double in on six years? Neither do we, so no caps to be worried about. But could the market be down 25%? Definitely! So we get the downside protection with no fear of upside cap.”
Here’s the problem. Yes, in any given year or two, the market could drop by 25%. But the chances of it being down six years from now are really small. If it drops now, it’s probably recovered by six years from now. And if it drops in year five, it probably grew so much in the meantime that it’s still above where we are now.
Timing the Bottom… at the Start
You would need your contract to expire in the bottom of a really bad bear market to make this work.
If you had bought one on October 12, 2016, it would have expired at the bottom of the 2022 bear market (25% down from the previous high). Good timing, right? No. The market was still up 67% over that six year period.
What if you bought one on March 19th, 2014. It would have expired at the bottom of the Covid Crash. Surely that would have limited your losses when the market was down 35%! Nope. It was still up 29% from six years before.
If had timed it perfectly to expire on the lowest day of the Global Financial Crisis, you would have had a 16% loss from six years earlier. But still, are you going to be that could at timing the next worst global financial crisis in a century… six years in advance?
I doubt it. Meanwhile you are still giving up dividends on all the other years that you are getting no benefits from it. The index annuity may be free, but the cost is high.
In Conclusion: Don’t Buy Index Annuities
There are only three reasons to buy an Index Annuity:
- Downside “Protection”
- Upside “Potential”
- “Free”
- Huge Commissions to the Financial Rep Selling It.
(I thought you said “three” reasons? I did. Only three of those are for you to buy. The fourth is for them to sell.)
There are seven reasons NOT to buy one.
- They lock up your money.
- They have hidden costs.
- Companies bait and switch options to reduce your return.
- They average less than the index they track by design.
- Caps and Floors are skewed down below average.
- You miss out on dividends.
- What they protect against is unlikely.
The Alternative: A Financial Plan
Instead of buying an index annuity, you could get a plan. You could start by reading by book 3D Retirement Income, which we’ll send to you for free at RetireMentorship.com or which you can read for free on Amazon Kindle or oder the physical book.
Then if you want help, you can work with a Fee-Only Fiduciary Certified Financial Planner. They will build that plan for you and help you implement it, all without selling you mediocre insurance products for big commissions. (Fee-only means no commissions, and no sales.)
Do not buy an index annuity. Make a plan instead.