Fixed Index Annuities: Not a Good Investment

When planning for retirement, many people look for investments that provide the growth needed to cover expenses while also minimizing the risk of running out of money in their lifetime. Fixed index annuities are marketed as an option to balance these needs. I recently attended an event offering these products. They were presented as a way to grow your savings with exposure to market gains while protecting your principal from losses.

In practice, however, these are financial products with significant drawbacks including high fees and low long-term returns. They are also often marketed to unsophisticated investors with presentations that leave out critical information. A less expensive and more flexible option is to create a traditional portfolio of stocks and bonds.

What Are Fixed Index Annuities?

Fixed index annuities are insurance contracts in which the company credits interest based on the performance of the chosen index, such as the S&P 500, but does not invest your money directly in the market. Instead, they use formulas to calculate your returns, often subject to caps, spreads, or participation rates. They combine features of fixed annuities and variable annuities, aiming to provide growth potential without direct exposure to market risk.

Complexity and Lack of Transparency

Fixed index annuities can be difficult to understand because of their complex terms and calculations. The formulas used to credit the interest paid are not straightforward, and the impact of caps, spreads, and participation rates may not be clear at the time of purchase.

This complexity can lead to confusion about how much you might actually earn and under what conditions. It also makes it harder to compare fixed index annuities with other investment options.

Limited Growth Due to Caps and Participation Rates

One of the main risks with fixed index annuities is the limited upside potential. While your principal is protected, the gains you receive are often capped or reduced by participation rates and spreads.

• Caps set a limit on the interest credited, regardless of how well the index performs. For example, if the cap is 5% and the index rises 10%, you only get 5%.

• Participation rates determine the percentage of the index gain credited to your annuity. A 70% participation rate means if the index gains 10%, your credited interest is 7%.

• Spreads or margins subtract a percentage from the index gain before crediting interest. If the spread is 2% and the index gains 8%, you receive 6%.

  
  

These features reduce your potential earnings, especially in strong markets. Over time, this can significantly impact the growth of your retirement income.

Surrender Charges and Limited Liquidity

Another risk is the limited access to your money during the surrender period, which typically lasts five to ten years, but can be even longer. If you withdraw funds beyond the allowed free withdrawal amount during this time, you will face surrender charges. For example, you may only be able to withdraw 10% of your money after the first year without penalty, therefore withdrawing any more will result in a 10% surrender fee on the funds above that allowed 10%. These surrender penalties are reduced over time, but may still exist for most of the life of your contract.

In addition, fixed index annuities often come with other fees that further reduce overall returns. These include mortality and expense fees to cover insurance risks and administrative costs. There can also be rider fees if an investor adds optional benefits like guaranteed lifetime income.

Real-Life Example of Fees

Consider Simone, a 60-year-old retiree who bought a $100,000 fixed index annuity with a 10-year surrender period. The annuity had a 4% cap and a 75% participation rate. In a year when the S&P 500 gained 10%, Simone’s credited interest was limited to 4%, not the full 7.5% she might have expected from the participation rate.

Two years later, Simone needs to withdraw $20,000 for home repairs and this withdrawal is subject to a 7% surrender fee. She will pay $1,400 in a surrender fee just to access her money. This example shows how caps and surrender fees can reduce returns and limit access to funds.

Inflation Risk

While fixed index annuities protect your principal from loss and offer some growth, they may not keep pace with inflation over time. The capped returns and fees mentioned above can reduce long-term real purchasing power, especially during periods of high inflation.

For example, if inflation runs at 3.5% annually but your annuity credits only 2%, your money's purchasing power loses value in real terms. Inflation risk is important to consider when planning for retirement income needs.

Credit Risk of the Insurance Company

Fixed index annuities are backed by the issuing insurance company, not by the government or any federal agency. This means your returns and principal depend on the insurer’s financial strength and ability to meet its obligations.

If the insurance company faces financial trouble or insolvency, your annuity payments could be at risk. State guaranty associations provide some protection, but coverage limits vary and may not cover the full value of your annuity.

Ordinary Income Tax Rates

While fixed income annuities offer tax-deferred growth, withdrawals are taxed as ordinary income rather than capital gains. This can result in higher taxes compared to other traditional investments in stocks and bonds, especially if you withdraw large sums in retirement. Additionally, early withdrawals before age 59½ may incur a 10% federal tax penalty on top of surrender fees.

Misleading Sales Practices

During presentations on fixed index annuities salespeople will show a chart with a smooth green line rising upward and to the right. There are no losses shown as the portfolio slowly increases in value every year. They will compare the green line to a red line for the S&P 500 showing a more volatile growth trajectory with wide swings in value. They are using this chart to promise retirees they will avoid this volatility by investing with them.

Excluding Dividends and Cherry-Picking Data

The most glaring misrepresentation in some of the charts I have seen is the intentional exclusion of dividends in the S&P 500 index chart when compared to a fixed index annuity. Over a 17-year period a $100,000 fixed income annuity investment is presented as beating the S&P 500 by $17,000.

However, if dividends were included in the S&P index returns it would have beaten the fixed index annuity by nearly $77,000 for a 34% higher return. Excluding the dividends when comparing these two investments is highly questionable.

Another strategy used by salespeople is to cherry pick one of their best fixed index annuity products and compare it to specific dates of return for the S&P 500 to make its performance look superior. What is funny is that in some of the examples of fixed index annuities that were presented, the S&P index beat their fixed index annuity even after the salesperson excluded dividends and excluded most of the post pandemic bull market in the S&P 500.

Better Investment Options Exist

There are a range of investment portfolios that can be created that will beat the returns of a fixed income annuity without the fees and complexity. Depending on your risk appetite you can consider these three diversified portfolios.

Some financial planners recommend risk averse investors have their age in bonds, so a 55-year-old would have 55% bonds and 45% in stocks. Each year, 1% more of the portfolio is allocated to bonds. This provides stocks to help create growth for inflation and bonds to reduce volatility. These portfolios can be created with minimal fees, full access to your money, and none of the surrender fees or limited upside potentials of fixed index annuities.

Regardless of the portfolio you create, it is always wise to have six months to a year of living expenses held in an emergency fund in the event of major market downturns which can derail long-term retirement goals.

For more detailed information on taxes in retirement and creating a plan for financial independence see Become Loaded for Life and the 10 Stages Workbook.