Why You Should NOT Buy Index Annuities

Why You Should NEVER Buy an Index Annuity

There are three reasons to buy index annuities. Here are seven reasons not to.

1. They Lock Up your money.
2. They have hidden costs.
3. Companies change the parameters after you buy.
4. They average less than the index they track by design.
5. Caps and Floors are skewed down below average.
6. You miss out on dividends.
7. 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:

1. Downside “Protection”
2. Upside “Potential”
3. “Free”
4. 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.

1. They lock up your money.
2. They have hidden costs.
3. Companies bait and switch options to reduce your return.
4. They average less than the index they track by design.
5. Caps and Floors are skewed down below average.
6. You miss out on dividends.
7. 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.

This article is educational only and is not intended to be investment, legal, or tax advice or recommendations, whether direct or incidental. Again, this is not investment advice. Consult your financial, tax, and legal professionals for specific advice related to your specific situation. Never take investment advice from someone who doesn’t know you and your specific situation. All opinions expressed in this article are those of the people expressing them. Any performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be directly invested in.