A bank teller told a client he should put his maturing CD in an investment that would provide a 4% guaranteed return instead of the .25% CD rate the bank was offering. Another client submitted paperwork to start receiving income from a maturing annuity and was called by a company representative wanting him to roll it into an investment that would give him ‘much higher returns.’
Index annuities are the new answer to your investment prayers, if you believe the promotions.
At the most basic level annuities are investments issued by insurance companies that provide a fixed interest rate return, similar to CDs. Some accumulate interest and can be cashed in after a period of time (deferred annuities) while others (immediate annuities) are similar to pensions. You give the insurance company a sum of money and they pay you a scheduled amount that’s based on an interest rate and the amount of time they promise to pay you. Simple, so far.
To remain competitive with other investment alternatives, insurance companies created variable annuities, which allow purchasers to divide their deposits among a list of mutual fund alternatives held inside the annuity. Variable annuities have been sold as a tax-sheltered way to invest in mutual funds, and they can be used to pay out a variable stream of income in retirement as well; however their fees significantly reduce what investors actually receive. According to a recent Forbes report, variable annuity contract fees range between 1.75% to over 3.25% each year, depending on the company. The mutual funds held inside the annuities incur management fees, and there is a length of time an investor has to remain in the annuity before they can take withdrawals, known as the surrender period. If money is taken out earlier, withdrawals are subject to a surrender charge ranging from 5 – 15% of the withdrawn amount. The costs and restrictions on variable annuities made them less attractive to investors over time, until the stock market decline of 2007 – 2009 inspired the insurance industry to promote index annuities as a solution.
Index annuities (also known as equity-indexed, fixed-indexed, and hybrid annuities) are variable annuities that promise the upside benefit of investing in the stock market, with a minimum guaranteed income benefit to protect your downside risk. They appear to be the ultimate investment solution for people who want stock market returns but also want to be sure to receive a minimum retirement income in the event of a market decline. But as you probably suspect, it’s not that simple.
Insurance companies have to make a profit to survive, and they’re investing in stocks, bonds and real estate just like you. They can’t offer you an investment that defies the basic principles of risk and rewards.
At a recent investment study group that Chris, Chip and I attended, a representative of a well known insurance company presented their annuity offering that promised a 55 year old a lifetime income equal to 3.5% of his original deposit, or $35,000 a year for a $1,000,000 investment.
In order to receive this guarantee, however, the annuity holder had to do the following:
- Add an additional 1.25% to the fees charged against his annuity account balance.
- Give up access to the $1,000,000 annuity account balance, plus the investment returns on that balance, once he begins receiving the guaranteed income.
- Give up the ability to leave a death benefit to his heirs equal to the annuity account balance, once he begins receiving the income.
Even though the investor receives a guaranteed bond-like return of 3.5% per year, the company requires him to invest his deposit 70% in equities and 30% in bonds. The annuity account balance is primarily invested in equities, but he is not receiving the full benefit taking this investment risk and having access to a growing account balance that you would expect over a 20 – 30 year investment period.
The annuity I reviewed had a total charge of 2.15% for its total benefits, but a guaranteed maximum charge of 3.3% – meaning the insurance company could legally increase it in the future. And that’s exactly what insurance companies are doing on annuities that were purchased by Baby Boomers years ago. A Wall Street Journal article on April 20th, They’re Changing Our Annuity!, described the changes being made by AXA Equitable Life Insurance, Manulife Financial, Hartford Financial and Aegon to alter investment options and increase the fees for the guaranteed income features in their contracts. Several were replacing mutual funds managed by independent fund companies with those managed in-house, allowing the companies to collect fees for mutual fund management as well as the fees they already collect.
There are several other issues to consider with these products:
- Not only are you limiting your ability to fully participate in stock market gains, you are giving up the ability to diversify your risk among a variety of companies. When you invest in an annuity, you are putting yourself in the hands of the insurance company and its ability to uphold a promise to pay you the income it is guaranteeing. Baldwin-United is a local example of an insurance company that failed in 1983.
- The S&P 500 experienced an annualized return of 9.68% over the 25 years since March 1988. If an individual divided $1,000,000 between 70% in equities and 30% in bonds as the insurance company requires, their equity account alone would have created a higher income stream over their lifetime, without locking away the principal.
- We are in a historically low interest rate environment. While 3.5% guaranteed returns look attractive today, it wasn’t long ago that money market funds were paying 6%. Variable annuities are designed to pay out an income over a person’s retirement lifetime, usually 20 -30 years. When interest rates rise and inflation has an impact, as they both inevitably will, having a low guaranteed income will not be very attractive.
All in all, index annuities require you to give up quite a lot in exchange for delegating your investment worries to someone else. If you are going to take risks, I think you should reap the rewards yourself.