Brad Tinnon

Brad Tinnon

What Is An Indexed Annuity?

Last week in my blog post titled Why I Hate Annuities, I talked about a client who is in an unfortunate situation with her annuity. What I didn’t mention was that she has an Indexed Annuity. These types of annuities are structured in way that significantly tilts the advantage to the insurance company instead of the investor.

WHAT IS AN INDEXED ANNUITY?

Indexed Annuities are products that are sold by an insurance company. The returns that you receive are tied to a stock market index such as the S&P 500. If the index goes up in value then you share in a portion of the returns. But if the index goes down in value, then you are “guaranteed” not to lose anything. And this ultimately is the appeal of the indexed annuity. 

NOT ACTUALLY INVESTED IN THE MARKET

It’s important to know that at no time is your indexed annuity actually invested in the stock market. Instead your money is physically invested in the actual insurance company. Therefore, if the insurance company were to struggle financially, your investment could be at risk. This is a very big risk, because you are invested in just one company. If instead you were invested in the stock market itself, you would likely be invested in hundreds, or even thousands, of companies. It’s for this reason that if you buy an indexed annuity then you should spread your investment across multiple insurance companies. Additionally, you should choose an insurance company that is highly rated

THE DECEPTIVE WAY YOUR RETURN IS CALCULATED

Believe it or not, the stock market index could actually go up in value, but you could earn 0% with your indexed annuity. This seems impossible considering that you are supposed to share in the returns when the index goes up. But unfortunately, it doesn’t always work that way.  The reason is due to how the insurance company actually / deceptively calculates your return.

Let me explain. Do you recall earlier when I said that you “share” in the returns of the index? Well, the way that indexed annuities work (in many cases but not all) is that you are capped on the return that you receive. For example, if the index does 4% one month, you may only return 2% due to the cap. However, the insurance company DOES NOT cap your down side. So if the stock market index declines 10% one month, you get credit for the whole amount. Then all the positive and negative monthly or yearly returns are added together to determine your overall return. If it’s positive, then that’s the return that gets credited to your account. If it’s negative, then you earn 0%.

As a result of this calculation, it can work out to where the stock market index as a whole could be positive but you earn nothing. Let me show you a real client example:

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As you can see in the chart above, the S&P 500 Index actually returned a POSITIVE 9.98% for this particular year, but the investor got credit for a NEGATIVE 5.76%!!!! While the investor didn’t lose any money (because the -5.76% calculated return technically means the investor earned 0% since they are guaranteed not to lose any money) they completely missed out on a 9.98% gain all because of the way the Capped Return is calculated. 

Look at the chart and you will see that in month 5, for example, the investor got full credit for the -6.188% return. However, in month 10, they only received 2.40% of the 10.095% return. And this is why the client earned absolutely nothing in this year.

In case you missed last week’s blog and are wondering why I am talking about a client of ours who did so poorly, let me assure you that this annuity was sold to her by a prior advisor. Unfortunately, we have to leave the annuity in place or else the client would face a $55,000 penalty.

WHAT COULDA BEEN

From time to time I hear people say that their investment has done very well. But then I ask them, “Compared to what?”. I don’t mean to undermine the investor’s experience, because if they’ve successfully been able to accomplish their goals with their investment then it is a good investment. But this does bring up the question of what the client would have returned if they had invested in a different manner. It’s a valid question because people generally want to maximize their wealth given a certain level of risk. In other words, if you had two investments to choose from with identical risk, you would likely choose the one that was expected to return more.

So, with that in mind, I thought it would be interesting to see what the return of the client above would have been if she had invested in a different manner.

Our client invested $60,000 into her indexed annuity in August 2004. As of August 2017, it was worth $119,000. That is a total return of 98% over those 13 years. In other words, the account almost doubled in 13 years. Seems like it was a good investment, right?

But what if she would have invested that $60,000 in the stock and bond market directly, say 50% stocks and 50% bonds, which is generally a very good portfolio for a retiree? How would she have fared? Do you think she would have ended up with more money than the annuity or less?

Invested in this 50/50 portfolio, she would have had a total return of 133%. This means that her $60,000 would have grown to $140,000, which is $21,000 greater than the annuity. Imagine if that $60,000 initial investment was a $600,000 investment. It would have grown to a full $210,000 greater than the annuity. Even if she would have invested much more conservatively, say 20% stocks and 80% bonds, her return would have been roughly the same as the annuity without the associated risks of the annuity.

A lot of talk (and sales pitch) is given to this idea of making money when the markets go up with a guarantee that you will never lose money. But as you can see the client did in fact lose money by not investing in a different way. It turns out that this was a $21,000 lost opportunity for the client.

I don’t think that all annuities are bad, I just think that they are often times “sold” to the investor without a proper understanding of how they work. But even if they were explained properly, they are so confusing that it is likely the investor wouldn’t remember what was told to them in the first place. And this complexity is one of the reasons that we usually steer clear of annuities.

I would love to hear any experiences (either good or bad) that you have had with annuities. Please feel free to share those below or share any comments that you may have.

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Brad E.S. Tinnon
CERTIFIED FINANCIAL PLANNER™
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