Ten years ago, when I was first getting into the financial industry, my dad showed me a brochure for what appeared to be the perfect investment. An investment that promised nearly all of the upside of the stock market with no downside. We both knew that if it sounded too good to be true, it must be, but we couldn’t find anything wrong. Well, it didn’t take long after my dad bought the annuity to realize that it wasn’t all that it was cracked up to be. The stock market was soaring higher, yet the annuity had returns like a CD. Ten years later, and a stock market returning nearly 15% annually, the annuity barely cracked 4% per year. So much for getting nearly all of the upside of the stock market. This post will help explain how fixed index annuities work, and the reasons you may want to avoid them.
The Basics of Fixed Index Annuities
First, fixed index annuities are like fixed annuities but instead of performance being based on interest rates, the performance is linked to a specific investment index, like the S&P 500. The main selling point of a fixed index annuity is that you will get the upside of the stock market without seeing any downside. As you probably have guessed though, and I should have realized when I first heard about them, the upside is also very limited. Each specified time period, either monthly, quarterly, or yearly, your account will be credited interest based on how the index performs. There is typically a cap, which maxes out the amount that you can be credited each time period, but the biggest benefit of fixed index annuities is that you can’t lose money during these time frames. Now, let’s discuss some of the negatives.
Huge Surrender Fees
Remember how I told you that the biggest benefit of fixed index annuities is that you can’t lose money? Well, why is that so many people actually lose money buying a fixed index annuity? Fixed index annuities carry huge surrender charges if you try to pull money out of the annuity early. Unfortunately, many people are ultimately frustrated at how the annuity is performing compared to what they were expecting, and therefore cancel the annuity within the first few years of taking it out. This results in huge fees and many times a loss in your principal.
Here is an example of surrender fees for one of the most popular fixed index annuity, Allianz 222.
As you can see, if you want out of this annuity within the first 10 years of purchasing it, you will be paying a penalty. Within the first three years of purchasing the annuity, you are paying a huge 10% penalty. If you are purchasing an fixed index annuity, it better be for the long haul.
Indexes don’t include dividends
Fixed index annuities have a lot of funny math that makes the product sound much more appealing than it actually is. One fixed index annuity secret is that you may get the price performance of an index, but that index excludes any dividends. This may not sound like a huge deal, but it is. Over the past 10 years, through 2017, the S&P 500 with dividends has earned 8.5% per year. Take out the dividends and the return is only 6.2% per year. By taking out the dividends you are losing out on over 2% per year in return, which is over 25% of the annual return of the index! Dividends are a huge deal, and failing to take into account these dividends kills the performance of fixed index annuities.
Simple not compounding interest
The other funny math is the fact that many annuity returns are calculated using simple and not compounding returns. Want to know how important this is? How about this Warren Buffett quote, “My wealth has come from a combination of living in America, some lucky genes, and compound interest.” There are some annuities that do use compounding, but annuity lingo can make deciphering the math very difficult. Still, this is a major issue if your annuity doesn’t use compound interest. For example, if you invest $100,000 and earn 6% per year, you will have nearly $180,000 after 10 years using compound interest. Using simple interest instead, you would only have $160,000 after 10 years. Both accounts earn the same amount, but using compounding and not simple interest, you end with 12% more over 10 years in this example. This is a big deal.
Hardly any licensing requirements
Want to get into a career in which, with almost no training, you can get rich quick? Start selling fixed index annuities. Fixed index annuities are insurance products, and therefore you only need an insurance license to start selling them and earn a commission. Have a week of free time? Perfect, because that is enough time to get a state insurance license and start selling these annuities. To me, this is a travesty. Fixed index annuities are one of the most complex investments out there, and the fact that you need no training in investments to actually sell them is ridiculous. I could go out and get an insurance license, sell this incredibly complex financial product which I know nothing about, and lock a person into this product for ten-plus years and know nothing about investing at all. Not to mention, because this is an insurance product and not regulated by FINRA, there is no prospectus required. Therefore, there is nothing to read to learn more about the product, even if you wanted to. This is crazy, but it leads us to the next point.
The sales commissions are incredibly high
One of the other selling points of fixed index annuities are that there are no fees. This may be correct, but we will never know because there is no prospectus, as we mentioned above. Still, if there are no fees, how can insurance companies pay huge commissions to their sales people on the sale of these products? Fixed index annuities have one of the highest commission schedules out there. It would not be surprising for a salesperson to receive 7 to 10% commission on the sale of just one product! If you use $500,000 to purchase a fixed index annuity, there is a good chance the salesperson will earn up to a $50,000 commission! So you have this product with almost no licensing requirement, that pays a huge commission. Buyer beware.
I guess I should say something nice about these fixed indexed annuity, because they aren’t all that bad. If you are a conservative investor and are looking for more return than a CD with no downside risk, a fixed index annuity may be fine. A fixed index annuity may play a role in your retirement portfolio, but that role should be for a fairly small conservative portion that you won’t be touching anytime soon. You want to make sure that you are working with a legitimate annuity salesperson, if there is such a thing, that can explain the ins and outs of the product. If the person you are working with is guaranteeing all of the returns of the stock market with no downside risk, runaway as fast as you can.