Taking a Look at Indexed Annuities


Q: My financial advisor recently suggested that I invest in an index annuity. He says the annuity will give me the stock market’s upside without the downside risk. It almost seems to good to be true. Does that make sense?

A: I generally do not recommend indexed annuities. The main problem is that they are expensive and very complicated. I have found that most people who buy them do not understand them. If you don’t understand an investment, you shouldn’t buy it.

There are two main kinds of annuities: fixed and variable. Fixed annuities pay a specific dollar amount at a specific frequency (usually monthly) for a specific period of time. The amount and timing of your payout are determined by a contract you have with the issuer. Payouts can either begin immediately or can be deferred to some future date. Money invested in fixed annuities usually earns a fixed rate of interest. The safety of your payout is based on the issuer’s credit worthiness.

Fixed annuities can play a valuable role in helping to protect you from out-living your assets. Your Social Security retirement benefit is a great example of a fixed annuity.

Variable annuities are completely different. Variable annuities are generally designed to help an investor accumulate tax-deferred savings. Money invested in a variable annuity goes into one or more subaccounts and is segregated from the annuity issuer’s assets. Subaccounts are like mutual funds and their value rises (or falls) as the market changes.

Equity-indexed annuities are technically fixed annuities, but your return is based on the performance of an underlying market index, like the S&P 500. A mathematical formula links the return on your annuity to the change in the index. This formula usually imposes limitations on your returns. Some limitations may be attractive, like limiting your downside, and are highly touted in the annuity sales literature. Other limitations are less-attractive and consequently don’t get emphasized as much.

For example, an annuity may cap your annual return. Suppose your annuity has a 10 percent cap. If the index goes up 15 percent, you will miss out on a large portion of the market’s return.

Your annuity may also give you less than one-for-one participation as the underlying index goes up. For example, if the index rises 10 percent, but your participation rate is only 75 percent, your return will only be 7.5 percent. Again, you miss out on a significant portion of the market’s gain.

You should also be aware that most equity-indexed annuities only pay you based on the change in value of the index, not the index’s total return. On the S&P 500, that difference will cost you about 2 percent per year.

Other, more subtle wrinkles may be embedded in the equity-indexed annuity formula, which is why you need to spend the time to thoroughly understand what you are buying. If your financial advisor is recommending this investment, he should be able to spell them out to you in a detailed and understandable way. If he can’t, get another advisor.

One final word on annuities. The variable annuity market is fraught with abuse, much of it targeted at seniors. That’s why 26 percent of state securities regulators identified variable annuities as the leading source of investor complaints or investigations. The NASAA, the professional organization of state securities regulators, specifically warned investors about the very high commissions paid to those who sell variable annuities. It also warned investors to be careful about hefty surrender penalties, which may make them unsuitable for seniors.


Steven C. Merrell  MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning.  Send your questions to: Steve Merrell,   2340 Garden Road Suite 202, Monterey, CA  93940 or email them to: steve@montereypw.com