Index annuities are selling like hotcakes these days. In fact, they are breaking sales records. But does that mean you should buy one? Are they great investments or are insurance sales sharks shoving them down investors’ throats with no mercy? Let’s take a closer look.
How Index Annuities Work?
The first thing to know is that index annuities share many attributes of fixed annuities. Like other contracts you invest a lump sum with an insurance company and they invest the money on your behalf.
While you leave the money with the insurance company, it grows tax deferred. Withdrawals are partly taxed as income rather than capital gains no matter how long your money is invested. And if you withdraw funds prior to reaching age 59 ½ you’ll get slapped with a tax penalty from the IRS. Of course, each contract is different but they all have surrender penalties. That means on top of the IRS early withdrawal penalty, the insurance company may penalize you when you make a withdrawal no matter how old you are depending on the contract you sign.
These characteristics are common to all annuities. What differentiates the index annuity is how the money is invested and (more importantly) how your returns are calculated.
How Is An Index Annuity Invested?
When you fork over your cash to the insurance company they invest part of it in the stock market and the other part in bonds. Depending on your contract, you earn a percentage of what they earn on your money. They can’t give you everything the annuity earns for a few reasons.
First, they aren’t in business to do you or anyone else any favors. They are in business to make a profit for their shareholders. Sorry Charlie.
Second, when you buy an index annuity the insurance company usually guarantees that you’ll never take out less than you put in. That “insurance” costs money and you pay this cost by being credited a smaller percentage of what the insurance company earns on your money.
How Much Will You Earn With An Index Annuity?
Your earnings are credited based on what the S&P 500 earns over a month, year or any number of years. But because of what I referenced above (and a few other reasons), you’ll likely earn a lot less than what the market earns over that time.
As a matter of fact, Fidelity Investments did some digging recently and discovered that a typical index annuity would have earned about 7% per year less than the overall market from 1926 through 2013. That’s right. Over that period, an index tied to the S&P 500 clocked a 10% average return according to Morningstar Inc. while the typical index annuity would have credited only 3%. That’s stinky.
Other Reasons Why Index Annuities Might Be Far Below The Market
Besides carving out a profit and paying for the “insurance” of your capital, insurance companies sometimes get very creative with how they calculate your return. Some use point-to-point calculations but others use all kinds of math tricks to average the return of the S&P 500 down and then shave off their profits and the insurance costs. This is a major contributor to the fact that back tested, the index annuity only credited 30% of what the actual return of the index was.
Why People Buy Index Annuities Anyway
Index annuities, like whole life insurance, is usually sold – not bought. Insurance agents get fat commissions when they sell these puppies. That’s why when you walk into to a bank or insurance agency, you’ll have to fight your way out if you want to exit without being saddled with an index annuity many times.
People are attracted by the lure of juicy stock market returns without taking the risk and to be honest it does sound good. But if these would-be investors ask to see the actual returns that actual investors actually received they’d probably think twice.
Certainly, it feels better and it’s easier to invest if you know your capital is safe. But remember, these investments are long-term – usually 7 to 10 years at the very least. And because index annuities gains, paltry as they may be, are taxed at income levels rather than capital gains rates, chances are high that if you do buy one of these bad boys, you’ll roll over your money to another contact when this first one expires. That means you’ll probably have this money invested in the market for decades – but you’ll earn quite a bit less than you otherwise would had you invested directly in the market. This of course assumes the market doesn’t do a complete face-plant. If the market does tank, the annuity would work well as you’ll never get back less than you put in as long as you don’t make premature withdrawals. But again, since these are very long term investments, time is on your side and the odds are on the side of those who invest directly in the market (even though of course that is no guarantee.)
So my question is, why not invest in a basket of mutual funds to diversify? This allows you to reduce your investment risk yet fully participate and capture 100% of the return instead of just 30% of it.
Sure, there is more short-term risk with this option as I said. But since you are likely investing for more than 10 years anyway, chances are very good you’ll make a whole lot more money.
Insurance agents are hungry to sell you index annuities. That’s why sales are so great. They may even try to entice you to get caught in their index annuity web by dangling hefty bonuses to sign on. Some go a step further by pitching you on guaranteed lifetime income provisions that some of these contracts offer but don’t fall for it. In most cases, you can do far better by investing for income on your own.
Knowing what you know now, are you still interested in index annuities? If so, why? If not, how are you investing for retirement income?