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Indexed Annuities – Pros and Cons

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A recent article by Investment News’ outstanding insurance and retirement products reporter Darla Marcado discussed the increased popularity of indexed annuity products (link may require free registration) among registered reps.  The zealousness with which these products are often sold sadly invokes images of the annual Canadian baby seal hunts in which the animals are often clubbed to death so as not to damage their valuable hides, with the remains then left to rot once the hides are removed.

Indexed Annuities – Pros and Cons

As with any financial product it is a good idea to look at the pros and cons of Indexed Annuities.

Indexed Annuities – Pros

For the life of me I cannot come up with a single reason why I would ever recommend an Indexed Annuity to anyone.  To be sure I wasn’t missing something I posed this question to my fee-only advisor study group recently and they agreed.

Indexed Annuities – Cons 

Unreasonably long surrender periodsI’ve reviewed a number of these contracts over the past couple of years and they all seem to have surrender periods of ten years or longer.  I can’t see giving your money to anyone who won’t let you have access to it for a decade.  You can of course annuitize and most contracts allow for the withdrawal of a portion (usually 10%) each year, but you’re prohibited from doing a 1035 exchange to another annuity contract if you find a better deal.

High fees and commissions.  These fees serve to reduce your returns and are often hard if not impossible to determine.  They can run in the 5% – 10% range and provide a great incentive for financial sales types to really push these products.  Make sure you demand that your rep disclose ALL commissions and fees that she might earn should you buy a contract.

They can be hard to understand.  With any financial product you should never even consider writing a check until you fully understand how it works and why it’s beneficial to you.  The premise is typically that you will participate in a portion of any gains on an underlying market benchmark such as the S&P 500 and that there is some minimum amount of return that you will make no matter how the index performs.  Make sure you understand the underlying formulas that determine your return and any factors that might cause a change in the formula.  Check out FINRA’s Investor Alert on Indexed Annuities as well.

Limited upside potential.  It is important for you to understand that this is not an equity investment.  Most contracts limit your participation in the underlying index.  For example in 2013 the S&P 500 gained over 32% so if your participation was limited to say 8% you would have missed out on a lot of the gain.

Confusing sales pitches. While technically not a feature of the product, it seems like the sales pitches for Indexed Annuities change to fit the times.  In the wake of the financial crises the fear mongering sales pitch was along the lines of avoiding the risk of the stock market while still participating in the upside.  These days it seems to be about the minimum returns as an alternative low-yielding CDs and other bank depository products.  Sorry there is no “wonder drug” financial product that I’m aware of.

Look this blog is not meant to provide readers with specific financial advice for their unique situation so please at the very least if someone is pitching you an Indexed Annuity (or any other financial product for that matter) ask them and yourself a few basic questions:

  • What’s in this for the financial sales person?  Is this recommendation based upon my best interests or based upon them earning a hefty commission?
  • Does this product make sense for me based upon my situation, my goals?
  • Do I understand how this product works including the upside potential and the downside risks?
  • What are the underlying expenses?  Is there a lower cost alternative that I’m not being made aware of?
  • Is this the best version of this type of product or just the version the sales person has available to sell to me? 

As with any financial product make sure you are buying an Indexed Annuity because it is right for you and not because you succumbed to a convincing sales pitch.

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Indexed Annuities – Da Coach Likes Them Should You?

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Mike Ditka recently began doing radio commercials for an insurance group touting their Indexed Annuity product. He ends one of the commercials with his characteristic “… tell them Mike Ditka sent you…” Given that Da Coach was a member of the last two Chicago Bears championship teams since the days of leather beater helmets (1963 as a player and 1985 as coach) he is perhaps the preeminent pitchman here in Chicago.

Alumnus Mike Ditka is a Hall of Fame tight end...

Should you pick up the phone and say that Coach sent you?  Let’s examine a few issues.

What is an Indexed Annuity?

Per the FINRA website, EIAs (Equity Indexed Annuities) are complex financial instruments that have characteristics of both fixed and variable annuities. Their return varies more than a fixed annuity, but not as much as a variable annuity. So EIAs give you more risk (but more potential return) than a fixed annuity but less risk (and less potential return) than a variable annuity.

EIAs offer a minimum guaranteed interest rate combined with an interest rate linked to a market index. Because of the guaranteed interest rate, EIAs have less market risk than variable annuities. EIAs also have the potential to earn returns better than traditional fixed annuities when the stock market is rising.

Reuters recently ran a piece on these products. A few points raised in the article:

— Hidden fees and commissions. Commissions typically run between 5 percent and 10 percent of the contract amount, but can sometimes be more. These and other expenses are taken out of returns, so it’s hard for buyers to determine exactly how much they’re paying.  

— Complex formulas and changing terms. The formulas used to determine how much annuity owners earn are so complex that even sales people have a hard time understanding them, and they can change during the life of the contract.

— Limited access to funds. Buyers who try to cash out early will incur a surrender charge that typically starts at 10 percent and decreases gradually each year until it stops after a decade or more.

–Limited upside. An annuity’s “participation rate” specifies how much of the increase in the index is counted for index-linked interest. For example, if the change in the index is 8 percent, an annuity with a 70 percent participation rate could earn 5.6 percent. However, many annuities place upside caps on the index-linked interest, which limits returns in strong bull markets. If the market rose 15 percent, for example, an annuity with a cap rate of 6 percent would only be credited with that amount.

Mike Ditka is not an inexpensive spokesperson.

Nor do I believe that ads on our local CBS radio affiliate are cheap. This goes to reinforce the point about high expenses and fees from the Reuters article. In fact I have been told that annuities are among the highest revenue generators for financial sales people, to me this creates a potential conflict of interest.

Additionally, any annuity product is only as good as the insurance company behind it. Before buying into any annuity be sure to understand who the insurer is and get information about their financial health.

An Equity Indexed Annuity might or might not be a good solution for your situation. In fact many of the proponents of these products point out that their performance has by and large been as expected over the past several years.

Rather than focus on any particular financial product or investment vehicle, start with a financial plan. Determine your financial goals, your risk tolerance, and your time horizon to achieve your goals. Look at your current resources and compare these to what you might need to accumulate to achieve your goals. Only then are your ready to look at what financial or investment products might be appropriate for you.

Lastly I would encourage you to ignore celebrity endorsements for financial products or services. While Mike Ditka might be an exception, there are many stories of athletes and celebrities making really poor financial decisions and being ripped off by financial sales people and advisors. If you buy the wrong brand of snack food based on their endorsement, not much downside. The same can’t be said if you pick the wrong financial advisor.

Please feel free to contact me with questions on Index Annuities or any aspect of financial planning.

Check out an online service like Personal Capital  to manage all of your accounts all in one place.  Please check out our Resources page for more tools and services that you might find useful.

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