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You’ve probably noticed there are more than a few things going on in the world these days that add to a sense of uncertainty, volatility, and fear.  People in general prefer some degree of predictability in all aspects of their lives, and personal finances likely reside near the top of that list.  That said, it shouldn’t come as a surprise that there seems to be an uptick in ads for annuities – financial products that promise a more predictable outcome in exchange for fees, upside, and flexibility.

An annuity by definition is a type of insurance contract.  The investor trades a lump sum or series of payments for a promise of regular disbursements at some future date.  There are many types of annuities with different characteristics.  Immediate annuities begin pay outs immediately.  Deferred annuities begin their pay outs at some point in the future.  Fixed annuities have a guaranteed return and steady payments.  By contrast variable annuities have payments based on performance of the underlying investments which change over time.  The various types of annuities have different pros and cons and fees summarized in the chart below.

One specific type of annuity I’ve recently seen advertised heavily is an indexed annuity.  These annuities have returns based on some stock index.  They promise participation in the index returns with limited downside risk.  The upside is typically capped and the downside protection limited.  For example, you may invest in a product today that is tied to the performance of the S&P 500 index.  It has a 6-year term, is subject to 325% maximum return, and promises 100% downside protection against the first -10% loss.  Meaning you can’t lose money if the market is down 10% or less at the end of the 6 years.

While this may appear like a great return profile on the surface, these products are not without significant trade-offs.  While many index annuity products advertise “no fees”, that doesn’t mean the investor isn’t paying a cost.  Most of the products I have seen have withdrawal fees, termination fees and other hidden costs.  Not to mention the “fee” built into the product via the upside performance restrictions.  An often-overlooked aspect of these type of annuities is that you forgo any dividend yield paid on the underlying index.  Historically for the S&P 500 this as amounted to 1.88% per year.  Investors also take on a higher tax liability since annuities are taxed as ordinary income not according to long-term capital gains.  Finally, but perhaps most punitive is the liquidity fee or lack of flexibility – in order to lock in the return characteristics, you must agree to let the insurance company keep your money for the entire term of the investment.  If you need or want your money sooner, you face high withdrawal and/or termination fees.

I was curious to see how the return profile of an index annuity product would hold up against a standard 60/40 balanced portfolio.  In researching, I found that the rolling 6-year return of the S&P 500 from January 1957 through December 2019 had an average price gain of 57.19%, or approximately 9.5% per year ignoring compounding.  86% of the rolling periods had positive returns while just 14% were negative.  94.7% of the time the return was negative the market was down by less than 10%.  Using the same example characteristics from before, we can assume an index annuity product would return 100% of the average upside.  Likewise, it would protect against any loss of principle in 94.7% of the periods.  In the other loss scenarios, the annuity would protect against the first -10% of the market, so a -15% market scenario would see the annuity down just 5%.

By comparison, a portfolio of 60% stocks and 40% bonds was positive 99.4% of the time over the last 50 calendar years and had an annual average return of 10.7%.  It was down more than 20% just one time and returned above 20% in a year 10 times.

Given similar long-term return expectations, lower fees, and the ability to maintain control over your money – a 60/40 balance portfolio provides a much better investment than just about any indexed annuity on the market.  It’s not to say all annuities are bad.  They certainly serve a purpose and can be the right tool in certain circumstances.  However, they are highly situational and there are far too many sales professionals out there paid high commissions to sell these products to investors who have better options.  Index annuities can sound fool proof but have many negative trade-offs and by design only outperform a low cost, well-diversified portfolio in very specific market conditions.

If you come across an annuity investment, or anything that looks interesting to you let us know!  An advisor at TAAG would be happy to review specifics with you to determine if it’s something that will enhance the probability of you reaching your financial goals.