Steven Merrell, Financial Planning: Take a look at index annuities
August 16, 2018 by Steven C. Merrell
Financial Planning
Q: I went to a dinner recently hosted by someone who was trying to drum up interest in fixed index annuities. She said these kinds of annuities would allow me to benefit from the stock market’s upside while guaranteeing that I wouldn’t lose money if the market went down. It sounds too good to be true, but the products are offered by some very reputable insurance companies. What can you tell me about them?
A: Fixed index annuities are getting a lot of attention lately. Many newly retired people are drawn to them because they are afraid the bottom is going to fall out of the stock market just as they leave the workforce. However, before you buy a fixed index annuities, take time to understand how they work and how they will perform.
The interest rate you earn on fixed index annuities is based on changes in the value of an underlying index like the S&P 500. Sometimes the index change is measured on a point-to-point basis, meaning between two specific points in time. Sometimes the change is measured on an average basis, meaning the average level of the index during a time period relative to a predetermined reference point.
The amount of interest you earn in each period is calculated using the annuity’s interest crediting formula. With some fixed index annuities your interest rate is capped, meaning the interest you earn for that period will never go above a certain level. For example, if your fixed index annuity has a 6 percent cap and the index goes up 4 percent in the period, you get 4 percent interest. However, if the index goes up more than 6 percent, you still only get 6 percent interest.
Sometimes fixed index annuities use participation rates when crediting interest. For example, if your fixed index annuity has a participation rate of 50 percent and the index goes up 10 percent, you get 5 percent interest. If the index goes up 30 percent, you get 15 percent interest. Participation rate fixed index annuities usually do not have caps.
Finally, many fixed index annuities have a spread or asset fee. A spread is the minimum amount the index must change before you begin earning interest. For example, if your fixed index annuity has a spread of 2 percent and the index goes up 6 percent, you get 4 percent interest. If the index goes up 2 percent or less, you get no interest.
Typically, an insurance company will use derivatives to protect you against downside risk. The cap rate, participation rate, and spread help offset the cost of your protection. If market volatility is high, the cost of the derivatives will also be high and the insurance company will be forced to use lower cap rates and participation rates to offset the higher cost. On the other hand, if volatility drops, the cost of protection will be lower and the insurance company can afford to give you more upside.
At regular intervals, usually once each year, your fixed index annuity will have a reset date. On the reset date, interest will be credited to your account and the insurance company will set new cap rates, participation rates and spread rates. This is one of the most disconcerting aspects of this investment. Every year the insurance company gets to change the parameters of your investment. If you don’t like it, you can surrender your annuity. However, you may be subject to steep surrender penalties depending on how long you have owned the annuity.
Although some sales people may try to position it otherwise, a fixed index annuity is not a replacement for stock market investments. Several studies, including one by Yale professor Roger Ibbotson, show that fixed index annuities produce returns more like long-term bonds. Unlike bonds, however, fixed index annuities can be expensive, are illiquid, are less diversified and bear significant exposure to the derivatives market. Bonds are sounding better and better.
Steven C. Merrell is an investment adviser and partner at Monterey Private Wealth Inc., in Monterey.
