Indexed Annuities – Investment Trap for Seniors

If you’re nervous about your investments these days, you’re not alone. But since you’ve got to invest your money somewhere, you might be tempted to buy indexed annuities. If you do get the itch to buy one of these “investments,” walk away and walk away quickly. Before I tell you why, let me explain the basics of indexed annuities.

Annuities are deposits with insurance companies. As long as your money stays in the account, you pay no taxes on the returns. But you are taxed on any profits as soon as you make withdrawals. This happens as soon as you tap into the annuity payout.

Fixed annuities invest your money and pay you a fixed interest rate. Sometimes the rate is fixed for a year. Sometimes your return is fixed for several years. Variable annuities invest in mutual funds. Your account values rise and fall with the value of those funds.

There are huge problems with variable annuities, but I’ve already covered that and I don’t want to digress. Please read “What Is a Variable Annuity?” for more info.

There is a third type of annuity, known as indexed annuities. These are really a form of fixed annuities. But your account values rise as market indexes go up – like the S&P 500. Your account is credited with a portion of the increase of the index. So, for example, if your indexed annuity is tied 60% to the S&P 500 Index and that index rises 10% for the year, your account will be credited with a 6% increase. Capiche?

Now, the reason that people scoop up these annuities is that they have downside protection. So if the S&P 500 declines this year by 10%, your account value won’t decrease a dime. That’s why people are willing to only accept a percentage of the increase – because they are protected against all the downsides.

Sounds sweet…right? Well, it’s not so simple. In fact, indexed annuities stink to high heaven. Here’s why:

1. Handcuffs

Once you buy an indexed annuity, you usually say goodbye to your capital. That’s because, in many cases, you’ll pay astronomical penalties if you want your principal back before an extended time frame. In one case described by Investment News, an 82-year-old woman was bamboozled into investing $1,000,000 into indexed annuities. It cost her $150,000 a few years later to get out of them.

2. Complications

The crediting calculations are very complex – something the slick salespeople rarely disclose fully. So you’ll rarely get all the interest you think you might have coming. My experience is that in generally rising markets, you’ll give up a great deal of the return due to these complex index calculations. And in a declining market, you’ll probably make out with close to nothing. True you won’t lose, but you would have done better in fixed alternatives in those cases.

Kent Smetters, a professor at the Wharton School and former official at the Treasury agrees. He says, “They’re [index annuities] terrible ideas for older people even though they’re peddled to them.”

3. High Commissions

I get offers all the time to sell this junk. Companies are happy to pay me 12% or more to peddle it. If they’re so willing to pay out so much, where do you think that commission is coming from? You better believe it’s coming right out of your return. That’s why those returns are so stinky.

Sales of these indexed annuities are through the roof because people just love the idea of downside protection and upside potential, but it’s all smoke and mirrors.

4. Other Problems

I generally like insurance companies (when they stick to selling good life insurance like term). But they stick it to you when you buy indexed annuities from them. The insurance companies take your money and buy stocks, bonds and derivatives, but they don’t credit your account with the dividends these investments make. That’s like paying full price for a car but only getting to use the front two wheels.

Better Alternatives?

According to William Reichenstein, professor of investments at Baylor University (per the Investment News article), indexed annuities perform worse than laddered CDs. And the laddered CDs provide more protection, much better insurance, less risk and more liquidity.

Remember, with the Mount Everest-sized commissions they pay the people who sell these things, insurance companies have to make up that money over time. That’s why they pay investors so little and keep the money locked up for many, many years.

When it comes to indexed annuities, this Pilgrim says pass.