The Dangers Of Indexed Annuities by Stephen Aust
This brief blog is a second BONUS July blog. Lucky you. It will not cover any market information. I will summarize the negative points of locking one’s money into an indexed annuity. Annuities are issued by insurance companies. Insurance companies are “for profit” institutions; they are not your “friend.” They will not produce an investment product that does not ultimately benefit the insurance company. There is nothing wrong with this, it is just a fact.
Indexed annuities generate a guaranteed level of income for the person that buys the annuity and the amount of income is almost always capped at a certain amount. The level of income is low and kept low. The money that one paid for the annuity is invested, by the insurance company, into the stock market and the insurance company keeps the high profits that stocks generate and they then give the client some income (in exchange for the insurance company keeping the vast majority of profits). During some years the stock market gains over 50% and many years it gains 15%-25%. Annuities typically generate 3% but sometimes slightly more. The insurance company keeps the difference between the two. Insurance products can also limit gains via “participation rates” and “percentage fees.”
Steady low single-digit gains will not begin to cover the increasing inflationary levels over the next two decades (which will eventually reach double digits) and this is an important point. Stock dividend payments do increase with inflation, as do floating-rate bonds.
Indexed annuities have pages and pages of un-readable fine print. They are like a bad blind date.
Insurance companies can go belly up while a diversified stock portfolio cannot.
As I sometimes say, stocks are not bombs ready to blow up at any minute, they are “partial ownership” in strong companies that also can pay dividends. Most market dips last for a few weeks, bear markets can last a few months and recessions can last a year… most investors can live through that. The real problem that people face is their unfounded fears and worries. The conditions that created a period as bad as 2008 will likely not occur again within the next decade.
The following chart (courtesy of Fidelity) shows the typical profits from stocks as compared to indexed annuities. Specifically it shows the 10-year rolling returns, which would be lower than some individual years for stocks. The chart shows the stock returns flowing up and down. BUT when the line is moving down it does not mean that stocks are losing money, it simply means that the total return was lower. For instance, the 10-year period that ended on January 1, 1950 shows stocks making an annualized return of 20% and the 10-year period that ended on January 1, 1957 shows stocks making an annualized yearly return of 10%, which is still very good. The indexed annuity earns a much lower 3%.
With annuities, there are huge commission fees taken out of your money and given to the person that sold you the annuity… either on day one or when you attempt to exit the annuity (after you figure out how low the profits actually are) or both. First year surrender fees are as high as 11.25% of one’s money and this makes for an illiquid investment at an extreme. So, on a $100,000 annuity, one may pay a commission of $8000 on day one and another $10,000 on day 350 to get out of it and this is not bad pay for the broker or agent that sold it to you… it is only bad pay for you.
The timeframe on annuities assures that it is highly unlikely that one would ever receive all of their money back and this defeats the entire purpose of “protecting” one’s money.
It IS important to hold income generating and lower risk assets in one’s investment portfolio and this is why MarketCycle holds bonds and preferred shares and even senior-secured bank-loans, with most paying around 5% interest. We currently only hold floating-rate income assets and they will adjust to pay more as rates rise (and rates will rise). These products are liquid and they can be changed along with the long-term changes in the market (such as inflation or Federal Reserve activity).
In 2012, FINRA (which is the U.S. governing body of investment professionals on a state level) issued an “Investor Alert” which warned against putting clients into indexed annuities and this now also holds true on a federal level. This says a lot.
At MarketCycle, our number one most asked question on our contact form (above) is “How do I get out of this stupid annuity?” We actually do have an answer that limits the pain of breaking free and I am certainly willing to discuss that with anyone on an individual basis.
So, what is my advice on buying indexed annuities? It’s simple. Hold some liquid bonds and other income generating assets in one’s portfolio rather than buying an annuity. Use insurance companies when you need to buy actual insurance.
Thank you for reading!
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