The Case for Indexed Annuities

One of the many drawbacks of record-low interest rates is that they have made creating an income stream in retirement significantly more complicated. Retirees and near-retirees can no longer rely on certificates of deposit and U.S. Treasuries to provide reliable, risk-free income. Interest rates are so low that these investments no longer keep up with inflation, which means investors effectively lose money over time. Likewise, the traditional 60-40 portfolio—60% stocks and mutual funds and 40% government bonds—has fallen out of favor with some analysts because of the abysmal returns from the bond portion.

That creates a conundrum for older investors who are reluctant to increase their exposure to an uncertain and volatile stock market. But the financial services industry—specifically, the insurance industry—has an antidote: annuities that provide higher returns than you’ll earn from CDs or government bonds, with limits on how much you can lose in a market downturn.

Annuities have a checkered reputation. Insurers have created a seemingly endless variety, with a seemingly endless list of bells and whistles, and the products are often poorly understood. And annuities are sometimes loaded with high up-front commissions that can motivate some insurance brokers to sell them to investors who don’t understand the terms and restrictions. Worse, the commissions limit investors’ returns because insurance companies adjust caps and other features to recoup the cost of the commissions.

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In recent years, though, companies such as DPL Financial Partners, which distributes annuities and life insurance to financial planners, have developed commission-free indexed annuities. The lack of commission allows certified financial planners to offer the annuities without running afoul of the fiduciary rule, which requires CFPs to put their clients’ interests above their own.

An increasing number of fee-only planners are recommending indexed annuities to clients who are near or in retirement and want the security of guaranteed income that will last the rest of their life. An annuity can also reduce your portfolio’s overall risk and provide peace of mind, especially when the markets play havoc with stocks and stock funds. But annuities aren’t appropriate for everyone—plus, some planners, insurance agents and brokers are still pushing expensive, high-commission products.

The indexed annuity menu

Indexed annuities come in different flavors, with different degrees of complexity and cost. The most basic is a multi-year guaranteed annuity, which provides a fixed rate of return over a specific period of time (typically three to seven years). They’re similar to certificates of deposit but usually offer higher yields. Currently, five-year fixed-rate annuities have yields that range from 2% to 2.75%, compared with an average of 0.35% for a five-year CD.

If a five-year yield of less than 3% leaves you underwhelmed, your financial planner may suggest a fixed-index annuity. With these annuities, you are protected from losses, and your returns are linked to a specific index, such as the S&P 500. Instead of investing your money directly in stocks, though, insurance companies invest most of it in fixed-income investments and use options to provide the potential for higher returns.

In exchange for protection against losses, fixed-index annuities limit how much you earn, even when the market is going gangbusters. For example, if your contract has a cap of 6% over a specific period of time, you’ll earn a maximum 6% rate of return, even if the S&P 500 index rises 25% during that same period.

For somewhat bolder investors who still want some protection from the ravages of a bear market, the insurance industry offers buffered annuities, also known as registered index-linked annuities, or RILAs. Buffered annuities more closely resemble equity investments in that you can lose money in a down market, says David Lau, founder and CEO of DPL Financial Partners. But the annuities have a floor, or buffer, limiting how much you can lose. For example, if the annuity has a buffer of 10% and the index it’s linked to falls 4%, you lose nothing. If the index falls 30%, though, you’ll lose 20%—not quite as terrible, but still a loss.

In exchange for taking on this higher level of risk, buffer annuities offer the potential for you to earn higher returns on the upside—for example, up to 15%, instead of 6% for a fixed-index annuity, Lau says.

The drawbacks

Many CFPs remain leery of indexed annuities, arguing that the amount of MacGyvering involved to create these products leads to unnecessary complexities that can mislead investors. Although indexed annuities may be appropriate for a narrow group of investors, the products in general are often loaded with fees and miscellaneous charges, says Ron Guay, a CFP with Rivermark Wealth Management, in Sunnyvale, Calif. And though indexed annuities are often marketed as low-risk or even risk-free, he says, “there are all kinds of risks when you take a closer look.” Some potential drawbacks:

Unpredictable terms. Insurance com­panies reserve the right to change the cap, floor or participation rate (see below) at the end of a prescribed period. For example, you could purchase a fixed-index annuity with an 8% cap and a year later see that cap lowered to 7%. Ask the insurer, or your planner, for the insurance company’s record with respect to previous caps. That could give you an idea of how consistent—or inconsistent—the terms of the annuity will be.

Surrender charges. Most multi-year guaranteed, fixed-index and buffered annuities impose surrender charges if you withdraw your money before a specified period of time (typically six to 10 years for fixed-index and buffered annuities). Some insurers allow withdrawals of up to 10% of your account value annually after the first year—but if you withdraw more than that, you’ll be hit with a surrender penalty of up to 15%. The fee gradually decreases each year and will eventually disappear, but withdrawing more than the permitted amount before the surrender period expires means you’ll lose money.

Opportunity cost. Historically, stocks have outperformed all other investments. Although investing in a fixed-index or buffer annuity gives you some exposure to the market, you’re still forgoing the potential for significant gains. In part, that’s because when the annuity provider calculates an index’s returns for the purpose of crediting your account, it typically doesn’t include dividends. That’s a significant omission. Over the 20-year period that ended in October, the S&P 500 index delivered an annual return of 4.26% without dividends and 6.3% with dividends, according to Fidelity Investments. That means an annuity investor would leave 47% of stock market returns on the table, and that’s before taking any caps or participation rates into account, Fidelity says.

For that reason, indexed annuities rarely make sense for long-term in­vestors, says George Gagliardi, a CFP with Coromandel Wealth Management in Woburn, Mass. Over the past 50 calendar years, the S&P 500 index has returned an average of more than 12% a year, he says. “If you were to apply a buffer/cap strategy to these 50 years of returns, you would end up with an average return that was 40% lower than the index itself,” he says. “That’s a high price to pay for reduced losses in some years.”

Are they for you?

Supporters of indexed annuities argue that they’re not designed to replace stocks or stock mutual funds. Instead, they can boost returns on the fixed-income side of your portfolio—a portion of the 40% fixed-income allocation in a 60-40 portfolio, for example.

The products also offer tax advantages, particularly for savers who have already maxed out on their contributions to 401(k)s, IRAs and other tax-deferred accounts. If you use after-tax money to buy an annuity, taxes on your earnings will be deferred until you withdraw the money. (To avoid a 10% IRS early-withdrawal penalty on your investment earnings, you must wait until you’re 59½ to take withdrawals.) By contrast, interest from CDs is taxed in the year it’s earned. With that in mind, Gagliardi strongly discourages clients from using IRA funds to buy annuities. “With few exceptions, annuities do not belong in IRAs,” he says. “It negates the tax-deferral aspect of annuities—because it is already present in IRAs—which is one of the more significant benefits of using annuities.” (See Should You Add an Annuity to Your 401(k)? for more on this topic.)

Another potential benefit: Most annuities contain riders that, for an additional cost, allow you to convert your account to a pension-like stream of income. This feature, known as a guaranteed lifetime withdrawal benefit (GLWB), provides a guaranteed payout from your annuity each year for the rest of your life—or, depending on the rider, for the rest of your life and your spouse’s life—even if the account balance falls to zero.

Lau says this feature is popular with near-retirees who like the idea of guaranteed income in retirement but want more flexibility than you get with an immediate annuity, which locks you into lifetime payments but also requires you to relinquish control of the money. With the GLWB, you can still take withdrawals, up to the account balance, at any time. The withdrawals will reduce the amount of your guaranteed payments. For example, suppose you have $100,000 in your account and your guaranteed payout rate is 5%, or $5,000 a year for life. If you later withdraw $10,000, your future payments will be based on 5% of $90,000, or $4,500 a year. Even with that added flexibility, you probably don’t want to invest more than 20% to 25% of your portfolio in an indexed annuity.

If you’re interested in investing a portion of your savings in an index-linked annuity, be wary of the hard sell. Don’t do business with an insurance agent or broker who claims that your annuity will deliver market-rate returns with no risk. “That’s how these products got a bad reputation,” Lau says. “The performance didn’t meet expectations.”

Consult a CFP who has experience with these products and can help you separate the wheat from the chaff. Unlike mutual funds, which can be compared fairly easily by looking at expense ratios, “it’s much harder to understand the costs of these strategies,” says David Blanchett, head of retirement research for Morningstar’s Investment Management group. “Get a planner that understands how they work.”

The Certified Financial Planner Board of Standards consumer website (www.letsmakeaplan.org) is a good place to start. You can search for a CFP in your area and drill down to determine an individual planner’s areas of expertise, including retirement income management and insurance planning.

How indexed annuities work

Indexed annuities are made up of many parts. Here’s a look at some of the terms you’ll encounter when considering one of these products, plus fees that will reduce returns.

Index tracking. Insurance companies use different time periods to measure changes in an index value for purposes of calculating your returns. Some base returns (or losses) on changes in the value of the index during a month, a year or longer; others may use average performance in the index over a specified period of time.

Cap. The upper limit on the amount you can earn over a specified time period. For example, if your annuity is capped at 3%, that’s all you’ll earn, even if the underlying index rises 15% over the index tracking period.

Participation rate. The percentage of the index’s return the insurance company credits to your annuity. For example, if the market rises 8% and the participation rate is 80%, the annuity would be credited 6.4%. However, if the annuity also has a cap, which is common, the amount of your credited return could be limited. For example, if the annuity in the above example had a 3% cap, your credited return would be 3%, not 6.4%.

Buffer (or shield). Insurance companies that offer this feature will absorb a certain percentage of losses before deducting the value of the loss from the indexed annuity. For example, if the buffer is 10% and the index declines 12%, the value of your annuity would decline 2%.

Spread/margin/asset fee. An amount that is subtracted from the gain in the index linked to the annuity. For example, if the annuity has a spread of 3% and the index gains 9%, you would be credited with just 6%. These built-in fees could have the same impact on your returns as an up-front fee or commission, even if the investment is marketed as a “no fee” annuity.

Surrender charge. Typically imposed if you withdraw all (or more than a specified amount) of your money before a period of time—usually six to 10 years—has elapsed. For example, a 7% surrender charge might apply in the first year of the contract, fall to 5% the second year and gradually decrease to zero in the eighth year.

Riders. Extra features, such as guaranteed lifetime income that begins once you retire, that are added to the annuity for an additional cost.

Other types of annuities

Besides the indexed annuities discussed in the accompanying article, these are the most popular types of annuities:

Single premium immediate annuity. With this product, you typically give an insurance company a lump sum in exchange for monthly payments for the rest of your life, or a specified period. In exchange, you usually give up the ability to take additional withdrawals from the account. With some exceptions, you can’t access your money for unexpected costs—which is why planners recommend investing only a small percentage of your savings. (See How to Create Income for Life.)

Single premium deferred annuity. You get guaranteed payments when you reach a certain age. For example, a 65-year-old man who invests $100,000 in a deferred annuity that starts payments when he turns 80 would receive about $1,568 a month, according to ImmediateAnnuities.com, compared with $485 a month if he were to start payments immediately. You can also buy a deferred annuity, known as a QLAC, in your IRA or 401(k), which also reduces your required minimum distributions when you turn 72.

Variable annuity. A type of deferred annuity sometimes used by high-income savers who have maxed out on other retirement savings options. You invest in mutual-fund-like subaccounts to create future income (usually in retirement). Earnings accumulate tax-deferred, but the underlying investments can also lose money. Most variable annuities guarantee a minimum income stream, often with a rider, but fees can be high.