What’s Inside an Indexed Annuity?

Annuities are a hot topic in today’s financial climate, as promises of “guaranteed returns” sound increasingly attractive in volatile markets. For retirement planners, the idea of locking in a set rate of return sounds much simpler and safer than picking stocks or finding a money manager you trust. One of the more common annuity products is the indexed annuity, which provides flexible interest based on the performance of a large market benchmark. Unlike the fixed annuity, which pays a locked rate for a period of time, indexed annuities can feel more like passive investing, with participation in market growth, and reduced downside when the market drops.

At Narwhal, we are hesitant to recommend annuities for several reasons, primarily due to internal fees and hidden costs that are often bundled with these investment products. Additionally, we believe that annuities generally provide meager returns when compared to traditional active or even passive investing strategies. Sure, annuity purchasers are paying for less risk, but their opportunity cost is significant. We’d like to break down a typical indexed annuity product and compare it directly to market returns (S&P 500). Our date range for this comparison stretches from 1999-2018, including 2008, a market crash that has led to millions purchasing annuities due to fears of another recession. As you will see, annuity products still lose over the long term, even in periods where volatility is prevalent.

Annuity Breakdown

This company offers three annuity options, with varying levels of “guaranteed return” depending on whether the initial investment is above or below $100,000.

Fixed Account – For the first five years of the contract, the purchaser will receive a fixed percentage of return (2.25% or 3.00%)

S&P 500 Performance Triggered – Every 12 months, the overall performance of the S&P 500 is used as the benchmark. If the S&P 500 sees any positive change, the purchaser receives a specified rate of interest (4% or 4.5%). If the S&P 500 sees any negative change, the account receives 0% interest and experiences no losses.

S&P 500 Cap – Similar to Option #2, this annuity relies on a 12-month performance period of the S&P 500. If the S&P 500 goes up, the account will receive that percentage change up to a certain percentage cap (5.15% or 6.50%). If the S&P 500 sees negative change, the account is credited at 0% and experiences no losses.

On the surface, these options look tantalizing. Anytime a company guarantees “0% participation in market downside,” human nature can’t help but tempt us to run towards this safety net. However, it must be remembered that annuity companies are profiting somewhere. And it’s on the upside. With potential returns capped, investors are locked into a very small range of growth, while the annuity companies profit on every basis point past the cap. Even with the occasional recession, markets bounce back fast enough for annuity companies to weather the storm in down years. The key here is understanding that the stock market is always climbing over the long term. If investors can stomach the volatility of down years with a disciplined approach, time will favor their patience.

In the line graph above, you can see the S&P 500 as the dark orange line; the Performance Triggered Annuity as the gray line and the Capped Annuity as the light orange line. As evident by the 2007-2009 time period, a down market has a much larger effect on the S&P 500 than on the annuities. Despite the volatility, the S&P 500 recovers, and by late 2012 it has already surpassed the annuity returns. To put it into real numbers, if you split $300,000 evenly between an S&P 500 index fund, the triggered annuity, and the capped annuity in 1999, here’s the returns you would see at the end of 2018.

As wealth advisors who hang our hat on active management, we understand that volatility can be intimidating to investors. However, we believe that packaged products like annuities are expensive, inflexible, and ultimately underperforming. If you’re curious about how active strategies can offer fuller market participation and want to know why that can be beneficial, feel free to reach out to us or attend any of our upcoming educational events.