No Down Less Up

Dennis Ho

INDEXED ANNUITIES have been taking the insurance world by storm. According to industry sources, sales of indexed annuities—also known as equity-indexed annuities or fixed-indexed annuities—topped $70 billion last year and estimates for 2020 call for continued growth in the market.

On the surface, indexed annuities seem simple enough: You deposit a lump sum and earn interest based on stock market returns, with a guarantee that your annual return will never be less than zero. In other words, you can get the upside of the stock market, but with your principal protected. While these products might make sense in certain situations, it’s important to grasp what you’re getting—and what the drawbacks are.

To understand equity-indexed annuities, you need to understand fixed annuities generally. Fixed annuities have traditionally been low-risk savings vehicles, similar to a bank CD, or certificate of deposit. Like a CD, you get a guaranteed fixed rate of return provided you hold the annuity until it matures, which might be just two years’ away or perhaps as long as 15 years. Also like a CD, your guaranteed interest rate is net of all insurance company charges, so there are no other fees or expenses to worry about.

Traditional fixed annuities can be attractive relative to CDs, because they usually offer higher rates of return. Recently, top five-year CDs were paying 1.5% a year, while a fixed annuity from an A-rated insurer was crediting as much as 3%. And because fixed annuities are insurance contracts, taxes on the interest are deferred until you withdraw the money.

Indeed, at a fixed annuity’s maturity, you can roll the funds into a new fixed annuity (or any other type of annuity) via a 1035 exchange and continue deferring taxes on the interest indefinitely. The downside of a fixed annuity: The money is not FDIC-insured, so you’re taking greater “counterparty” risk, meaning there could be problems if the insurer got into financial trouble. In addition, there are heavy surrender charges if you withdraw your money early.

Finally, once you deposit money into a fixed annuity, you must keep it inside an annuity until at least age 59½. What if you pull money out earlier? There’s a 10% tax penalty on withdrawals, even if the specific annuity you own has reached its maturity. This final point generally makes fixed annuities suitable only for those close to or in retirement.

That brings us to equity-indexed annuities. They’re a twist on the fixed annuity product. Instead of crediting you with a fixed rate of interest, you get interest based on the return of a stock market index, like the S&P 500. At the same time, if the index return is negative in any given year, you get a 0% return, so your principal is protected.

How can insurers offer this? Consider the earlier example of a five-year traditional fixed annuity. Rather than pay you the 3% interest, the insurance company takes the interest you’d normally receive and instead purchases derivatives that increase in value if the stock market goes up. If the market performs well, the gain in the derivatives is used to pay you interest based on a predetermined formula. If the market goes down, then the derivatives expire worthless and you don’t get any interest. Indexed annuities can be attractive for individuals who want a principal-protected investment with the opportunity for higher returns than bonds or similar conservative investments.

But there are several caveats to be aware of. First, because of today’s low yield, the interest payments generally aren’t enough for insurers to purchase full exposure to the index. In many cases, your annual return will be a portion of the index return based on a “cap rate” or “participation rate.” For example, a 5% cap rate means you’ll get the next year’s index return up to a maximum of 5%, while a 70% participation rate means you’ll get 70% of the index’s return over the next year. The amount credited to annuity holders is based on share price changes only, with dividends excluded.

In years when the stock market does well, the indexed annuity will likely underperform significantly. Yes, the annuity will outperform when market returns are negative. But that’s not enough to offset the lost gains in good years. Result: Indexed annuities will generally underperform the market over the long term. You might be okay with this, because you’re looking to take less risk. But buyers should be aware that indexed annuities are not a substitute for owning stocks, which is how many insurance agents position the product.

Second, your participation rates can change over time. The initial 5% cap rate you signed up for can be changed each year by the insurer as derivative prices change. This can be good if interest rates rise and the cost of derivatives becomes cheaper, but bad if the opposite happens. Think of indexed annuities as akin to floating rate bonds—but in this case it isn’t your interest rate that fluctuates, but rather your participation in the stock market’s performance.

Third, it’s impossible for the average investor to assess whether they’re getting a good deal relative to other investments. Is a 5% cap rate on an S&P 500 indexed annuity a good value—or should it be 10% based on current market conditions? With traditional fixed annuities, you can look to bank CDs to assess whether you’re getting a good deal. But there’s no similar external benchmark for equity-indexed annuities.

Finally, as with other annuities, advisors are paid via commissions. In many cases, longer lock-in periods and more complicated products mean higher commissions for advisors, so they have an incentive to steer you toward these products. For example, a “plain vanilla” five-year fixed annuity might pay a commission of 1% to 2%, while a 10-year equity-indexed annuity could pay advisors 5% or more.

Dennis Ho is a life actuary and chief executive of Saturday Insurance, a digital insurance advisor that helps people shop for life, disability and long-term-care insurance, as well as income annuities. Prior to co-founding Saturday, Dennis spent 20 years in the insurance industry in a variety of actuarial, finance and business roles. His previous articles include Questions I’m AskedRetire That Policy and Care to Choose. Dennis can be reached at or via LinkedIn. Follow him on Twitter @DennisHoFSA.

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